It’s been absolute carnage for the past couple of days and the wash out so far looks a little like this. Lehman has filed for chapter 11, Merrill’s is being acquired by the Bank of America — and, following fears that it may be unable to raise sufficient capital, AiG looks set to at least be getting some Fed support, with the Wall Street Journal reporting that the Fed has asked Goldman’s and JPMorgan to help make $70-75 billion available to the firm; and that they’ve agreed.

The seriousness of this issue is clear — Lehman reportedly holds $600 billion of assets, which would make it the largest corporate bankruptcy. The worry is that any ensuing asset price free fall is just going to create a domino effect — further write-downs, further inability to raise capital and so on.

The IMF doesn’t think we’ve passed the worst — the managing director of the fund suggested that even more consolidation in the financial services industry is probable and predicts the decline of the stand-alone investment bank — which may be behind rumours going around of two large US investment banks possibly merging.

Needless to say, the liquidity premium has blown out — Libor-OIS, at 104bps, is a tick or two below the highs made in December and up around 25bps over the week. The BBSW-OIS, at 58bps, has spiked sharply also (about 20bps higher).

The Fed funds rate actually shot up to 6 per cent, easing only after the Fed added $US70 billion through two overnight repos. Fed futures have rallied sharply and are now pricing in an 82 per cent chance of a rate cut at this meeting and have priced out any hikes. That said, I’m not as sure the Fed will cut at this meeting, with an already negative real Fed funds rate. Past rhetoric has suggested that the Fed would respond with other measures first – which they’ve done – for instance, by pumping that $70 billion of liquidity into the banking system and widening their accepted collateral (to include equities). Clearly you can’t rule it out, but I reckon a Fed cut would be further down the list of possible solutions — not up front.

It’s a different story for the RBA, however, and this has got to keep an October cut live — financial conditions aren’t easing and don’t warrant a restrictive monetary policy stance (the market is pricing in 100 per cent chance of a cut at this meeting).

So it’s all about risk aversion and fear — CDS has blown out (itraxx Europe about 30bps), swap spreads have widened and the curve steepened.

Equities got absolutely smashed — given from the open with no respite for the rest of the session – to post the biggest one day fall since 9/11.

Financials were hit particularly hard, some brand name stocks down about 60 per cent. Overall the S&P500 financials index dropped 10.4 per cent, while the benchmark S&P500 was down 4.7 per cent (1192.7). The Dow fell 4.4 per cent (10917.5), while the NASDAQ fell 3.6 per cent (2179.9). SPI futures fell 2.7 per cent.

Rates again had a choppy session, with bull steepeners in play as the curve rallied from 20 to 30bps since Friday. Safe haven buying intensified bullish sentiment on very heavy volumes last night — trading through Brokertec running at about 80 per cent above an average Monday. The 2s were most active but on a relative basis 10s and 30s were more heavily traded as investors sought their higher yields. Dollar-flows were sizably negative in 2s and 5s and positive in 10s and 30s. Trading ranges were much wider than average. At the close 2s were 1.79 per cent (from 1.88 per cent at 1630), 5s were 2.6 per cent (from 2.64 per cent) and 10s closed at 3.45 per cent from 3.51 per cent. Having gapped higher on a combination of roll and safety flows, Aussie 3s were up another 7bps last night (94.78) while 10s were up 4bps.

Given what’s going on the events of the day don’t matter that much — we’ve got the RBA’s minutes for the September rate cut meeting, which follow Steven’s testimony to parliament, so it’s not likely they will contain anything earth shatteringly new — though further cues from the tone of the minutes will, as always, be critical — when it comes to the RBA you can’t have too much information. The RBA is on data watch — most of which has probably come out in favour of being on hold for October. But the above events suggest to me that closing the door on an October rate cut is simply premature.

In the US CPI data is likely to moderate, though from a high level. In any case this is secondary data in the wake of recent events. The FOMC is expected to hold rates steady at this meeting and I think a cut this year is unlikely despite the imminent collapse or otherwise of some financial institutions. Fed rhetoric has been pretty consistent on this front, and I buy into the idea that it is politically expedient of them to allow the financial landscape to be rearranged a little (though not collapse of course), which is why they are pumping in more liquidity and widening accepted collateral to equities, of all things.

In Europe, there another ZEW print in Germany and the market expectation is that this will improve somewhat –unlikely, I would think, but irrelevant — the survey is pointing to ongoing economic weakness. Otherwise Euro zone CPI is expected to be confirmed at 3.8 per cent, while UK CPI is expected to accelerate in August though core should remain unchanged.

Adam Carr is senior economist at ICAP Australia.

Peter Fray

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