Shown below are a long (W-VXO) and short term (D-VXO) chart of the VXO Index. As we pointed out in last week's Speculator, there has never been an historical example of the VXO rising as high as 45.81 (the September 18th high) without this index following on to top at least the 50 level. Most moves in fact ended up somewhere in the high 50's to low 60's - the reason for this being that once the investing public reaches a certain level of panic, it tends to feed on itself until a final crescendo has been reached.

While T-bills yielding 2 bp may represent the ultimate capitulation in fixed income markets, it may be that equity markets still need to experience this climactic process. The VXO will be a good guide as to whether this is occurring. The index is currently at 44.45, up 5.04 points on the day and just below the September 18th high. Note that should the index break out, the amount of time spent above 50 is typically very brief and would represent a potential turning point in this long, powerful downwave.

With all the chaos surrounding the failure of the Treasury bill to pass the House vote, it is important to realize that the greatest losses in asset markets today are very much concentrated in commodities and emerging markets. Crude oil remains of paramount importance to this complex and today's price action can only be described as horrendous. Writing last week, we warned that the faster a bear market rally unfolds, the shorter the time it tends to last and the veracity of that rule can be seen today. At the current time, Crude is just above $95.80, a fall of over $14 from the high recorded by the current November contract a week ago (we are ignoring the massive spike at expiration in the October contract that is shown on the chart for obvious reasons). We would expect to see a test of the recent low at $90.51 and see no reason to second guess our intermediate target of $85 in the coming weeks.

The VXO has fulfilled our minimum requirement of trading above the 50 level intra-day. All signs are that this is the sort of climactic event that marks the termination of a major sell-off. The highest VXO reading since 1987 is 60.23 (recorded on October 12th 1998). Other peaks include 57.31 (September 24th 2001) and 56.74 (July 24th 2002). It would therefore seem likely that the ultimate high in volatility will be recorded in the next 24 hours or so, assuming that this has not already occurred.

Note that the all time high in the VXO remains the remarkable level of 172.79 recorded on October 20th 1987 but while any that has happened can happen, we very much doubt that anything higher than a mid-high 50's level will be seen this time around.

JPMorgan Buys WaMu Deposits; Regulators Seize Thrift

Once more we see the predictive quality of the Treasury swap spread. WM's demise has been well telegraphed and openly discussed and hence should not rile the markets at a time when all attention will be focused on the Capitol Hill/Treasury stand-off. On the surface, this appears to be a steal of a deal for JPM who get to significantly augment their retail account base and geographical reach without taking any responsibility for WM legacy business issues. It also simplifies the bureaucratic burden on the FDIC who will now not be required to service this huge retail operation while the bank is under its control. Unfortunately the financial cost of winding down WM's balance sheet will still be the FDIC's responsibility and this is likely to prove to be expensive enough to require a recapitalization of the FDIC either through a levy on deposits or direct Treasury cash infusion. We favor the former but recognize the latter is more likely in these interventionist days.

Other points to consider are that the CRE market has just lost another significant loan originator following on from LEH. Also with regard to retail space in NY in particular, the huge overlap between the JPM and WM branch network would seem likely to result in a large degree of consolidation and further pressure on an already weakening rental market.

The chart below is an update to the "Speculator Extra" that we published on September 4th comparing the price of Fertilizer (Decyfer DAP Gulf Price) with the performance of the DAX Ag Tech index over the last cycle. The Black line is Fertilizer price, Red line is DXAG Index, Green line of lower chart is the spread between these 2 prices. In our original piece, we pointed out the remarkable performance of the Ag Tech sector has been outpaced by Fertilizer prices by a factor of almost 2x and that this allowed participants and analysts to make the case that the sector continued to offer good value at its newly inflated level. The stability of Fertilizer prices also led to claims of remarkable value as the Ag Tech sector corrected this summer. Our concern was that the illiquid nature of the Fertilizer market was simply hiding a change in the clearing price of this commodity.

3 weeks later, we see that the price of Fertilizer has dropped by an abrupt 10%. While this move is not enough to change the fundamental argument behind this sector, we strongly believe that perpendicular markets do not suffer small corrections. They either accelerate higher or collapse. Furthermore, the illiquid, opaque nature of a market like Fertilizer would tend to make the correction all the sharper once it commences.

There is a clear and dangerous stand-off developing between the credit markets which are demanding a swift finalization and approval of the Treasury plan and Capitol Hill that wishes to debate and modify these proposals. This is most clearly shown in the chart of 3-month LIBOR where US rates (black line) spiked another 29 bp this morning and are now 3.76%, 176 bp above the FDTR. Note that UK LIBOR and EURIBOR have also moved higher in recent days but not by anything of the magnitude of US rates. Treasury swap rates also show a very extended level of stress.

The 5-year swap rate hit 128.9 bp this morning but has since moderated to 119 bp - still an extremely high reading. Swaps at this level typically indicate a major player in the MBS arena is in the process of terminal decline, with WM clearly the most likely institution at the current time.

As we discuss at some length in today's Speculator, we do expect a deterioration of credit metrics to bring a much needed dose of reality to the political process. We do believe that a credible plan will be agreed to in the next 24 to 48 hours and that this would be greeted by a powerful rally in the equity markets and a meaningful improvement in credit metrics. We would therefore be patient holders of long positions should equity markets respond badly to continuing gridlock early Thursday and would consider adding to positions should a deeper test of last week's lows unfold.

Fortis Drops to 13-Year Low on Funding Concern

Note that Fortis is on a "No Naked Sale Short List" - so we have our first anecdotal piece of evidence that banning short sales is of little help to a company's equity in the face of bad fundamentals.

The Headline number of new homes sold (red line on chart) came in some distance short of Industry estimates at 460K (survey 510K); however, it should be remembered that August was the height of the GSE turmoil and mortgage origination was impacted which presumably led to the postponement of a number of August closings. As the chart below shows, at the current level of activity, US Home new sales is now closing in on the nominal lows reached in the late 1960's and 1970's even though the US population base is clearly far larger today as is the proportion of population owning rather than renting. It is therefore hard to see much further deterioration in this metric and we may even see a little post-GSE bailout bounce in September's data.

The far more interesting story comes from the continued shrinkage in New Home Inventory (black line). This fell by 19K homes, a record drop for a single month (beating last month's 16K), even though sales activity was extremely light. The 12-month ROC (green line, bottom chart) shows that inventory is now dropping at an annualized rate of 23.45%, a new record pace of decline. We continue to believe that inventory data will lead all other metrics concerning new home sales. By the end of the 4th quarter, it seems likely that inventory will have fallen below its 30-year average of 350K homes at which point other data should start to show clear signs of recovery.

Credit markets remain deeply stressed this morning with a degree of deterioration visible from yesterday's action. 5-year swaps have risen up to 114 bp, a level that has previously indicated a forced unwind of a major player in the mortgage market. Scanning the likely victims, WM would seem to be the name that comes to mind.

The 3-month Libor chart is the real shocker of the pack, since this shows that this key interest rate has risen up to 3.47%, almost 150 bp above the FDTR which it supposedly tracks. It is important to remember that 3-month LIBOR remains a key benchmark for commercial loans, which have effectively risen in price by 75 bp in recent days. The cost to the commercial banks on the other hand is not clear since they have access to the various FRB lending facilities at significant discounts to LIBOR.

Finally, the 3-month T-Bill currently yields 70 bp; it is a sign of the times that one can almost consider this to be a "healthy" reading. All in all, we are set for another difficult session as the market remains a jittery spectator to the somewhat gladiatorial congressional hearings over the proposed emergency FRB and Treasury action to stabilize the financial markets. It would not be surprising to see a further deterioration in credit markets force a dose of reality onto the key actors in this drama.

Buffett Calls Crisis an 'Economic Pearl Harbor,' Backs Paulson

The Buffett investment in GS and subsequent interview with CNBC has the potential to be a turning point in the current phase of this crisis. Firstly, the investment places a floor under one of the two surviving independent bulge-bracket firms and the importance of this is not to be underestimated. Secondly and perhaps more importantly, you have one of the few credible voices left in the financial sector coming down firmly on the side of the Paulson/Bernanke "RTC II" plan. This support comes at a time when there is a significant danger of a credible plan failing to be approved in an acceptable time-frame with Congress understandably hesitant to grant such draconian powers without due process. An outside voice preaching reason at this critical juncture is thus to be welcomed and the odds of a successful deal being struck have increased appreciably in our opinion. We would expect equity and credit markets to respond very favorably to a credible deal being put in place and would therefore be prepared to hold onto volatile long positions during what should still be a nervous near-term trading environment.

Although credit markets have improved from the extraordinary readings witnessed last week, they are still demonstrating a very significant degree of stress. Looking at our favorite measures, we see that the 5-year swap spread has risen back up to 109.5 bp, a dramatic turn around from Friday's low of 93.10 bp. Agency spreads are behaving better (as would be expected given the Conservatorship of the GSEs) but at 85 bp are still much higher than one would expect given the Treasury's decisive action.

3-month T Bills are now yielding 85 bp - this is an order of magnitude higher than 2 bp but still far lower than the FDTR at 200 bp than would be seen in more "normal" times. It seems unlikely that the broad equity market will be able to recover until these measures of financial stress show considerable improvement; we will therefore continue to monitor them closely in the days ahead.

It is starting to look as if the market is looking to retest last week's low in the near term. Support at the 1200 level just gave way in the SPX index and the VXO is threatening to move back above the 40 level. One technical issue that still nags at us is the fact that the VXO has never gotten as high as it did last week (45.81) without going on to surpass 50. There is a first time for everything (particularly in these highly abnormal times) but it may well be that we will need to endure another spike in volatility until a dependable bottom is put into place.

While documenting crude oil's rapid decline off its early July all-time high, we tried to warn readers that while crude seemed likely to lose the majority of its 2003-2008 gains over the next 18-24 months, this decline would be punctuated by some remarkable rallies. As a rule of thumb, the earliest rallies in a bear market tend to be the most impressive as the fundamental story is typically yet to turn decisively and many participants are willing to believe that they are capturing a long awaited buying opportunity. At the same time, those participants who built short positions tend to have got a little too aggressive and are thus vulnerable to being squeezed.

The last 5 sessions for crude are a textbook example of this sort of activity and have taken crude almost $15 higher from its recent low. As the lower 5 day rate of change (ROC) chart shows, this is the fastest crude has risen over this time period since our Bloomberg data commenced in 1986. While some commentators are explaining this to be linked to increased confidence in the global economy following the announcements of Treasury/FRB initiatives to stabilize the financial system, we do not find this to be a credible argument. Instead we suspect that the severe dislocation of all asset markets last week has somehow triggered a massive forced buy-in of crude contracts. The most likely suspects are either the legacy LEH or AIG books, both of which are subject to radical shrinkage at the hands of regulators and margin clerks but it is also quite possible that other HF and proprietary desks have found themselves sucked into this process's wake.

Whatever the cause, those looking for an insight into the strength of the global economy would do better to look elsewhere and again, reaching for our "bear market textbook," we should point out that the sharper and higher the rally unfolds, the less time it typically remains in place. It is clearly too early to take the other side of the trade but patient investors will probably get a useful entry point in the coming sessions and any weakness in consumer-related equities (particularly home-builder, aviation and retail) should be treated as a buying opportunity. retail) should be treated as a buying opportunity.

Blew out to $20 at one point this afternoon. $2 is normally considered to be an extremely wide margin.

At least part of today's spike is expiration related - today is the last day of trading for the current October contract. Note it is trading $5 higher than tomorrow's November contract - another sign of the particularly wild ride in all asset markets at present.

Russia, Brazil Lead Record Emerging Market Gain; Bonds Rally

Nothing is a powerful as the first stages of a recovery rally in an asset class that has recently made the transition from a parabolic bull market to a bear market. Those who experienced the Nasdaq bear market will remember this well. For instance, on January 3rd 2001, the NDX Index rallied 18.77% following the Greenspan Fed's emergency rate cut (the first in the 550 bp 2001-2003 rate cut cycle).

In the case of the NDX, the powerful rally followed a fall of 71% from its March 2000 high. By its end in May 2001, it had taken the index up 53% from its January low (see chart below). Of course after the rally peaked, the index's downdraft promptly re-exerted itself and the index broke down below its January low just before the September 11th attack. It is clearly too early to be sure that today's gains in EM will hold, but we do believe that a similar bear market recovery rally is going to unfold sometime between now and the begining of the 4th quarter.

Readers may recall that we circulated this chart of multiple CMBS spreads in late August, pointing out that spreads had recently widened considerably and asking the question as to what was the cause. That question has clearly been answered many times over in recent days. In regards to CMBS spreads, it seems clear the LEH's demise is by far the most important of the multiple events that have transpired, since they were very much the dominant provider of Commercial Mezzanine financing in recent years. It therefore comes as no surprise that the "A" spread (black line) has been particularly badly hit in recent weeks.

Note that none of the myriad of policy responses announced in recent days are designed to address problems in the commercial credit market, partly because the authorities are simply overwhelmed by what they have on their plate with residential mortgages and Wall Street balance sheets and counterparty risk. However, it is also important to realize that the dramatic deterioration in commercial credit (and hence the potential value of commercial real estate) has still been largely ignored by market participants. We do think this is likely to change and that the locus of concern is going to shift towards commercial real estate and credit in general and the REIT sector in particular in the coming weeks.

Homebuilding stocks remain very much at the "sweet spot" of sectors that are positively affected by the rush of proposed legislation. Most obviously, the proposed use of Treasury funds to buy large amounts of agency paper will collapse agency spreads and lower mortgage charges, but the renewed stability of the financial sector (presuming that this does occur and remain in place) should also increase the supply of private sector credit for sensibly underwitten residential mortages. Finally we would see the net effect of the traumatic last 2 weeks to result in an improvement of consumer sentiment although it may take some time before this week's panic subsides.

Looking at the chart below, we can see that the S15HOME Index has broken out again today. More importantly, although this index was extremely volatile over the last 2 weeks, it never came close to actually breaking down, a very significant accomplishment. Finally this sector has quietly outperformed the SPX by a considerable amount during the 3rd quarter. Important nominal and relative resistance lies ahead but if these can be overcome (some consolidation may be required), strong gains could occur through the 4th quarter.

Money Funds Show Holdings, Pledge Caution After Lehman Losses

Note BAC guaranteed to "hold the buck" in its money market funds (though apparently there is no danger of the NAV being worth less than $1). We had predicted that money-center banks would issue such guarantees since they rely on the credibility of their money market funds for their entire deposit base.

U.K. Retail Sales Unexpectedly Rise for Second Month

We have been gently recommending UK retailers for several weeks since we believe that sentiment towards them has been overly negative. A BOE rte cut would shift us more positively behind this sector but we note that most of the maintstays of this sector have held up quite well during the current global sell-off.

New Wall Street Can't Escape New Regulator: Brendan Moynihan

An excellent commentary that attempts to forsee some of the changes that our industry is about to experience.

As the SPX threatens to break down below yesterday's low the VXO index has broken through the key 40 level. As we wrote in this morning's Speculator, moves that extend more than a point or two above 40 tend to rapidly move to the high 50's/low 60's.

One interesting new factor here is the "emergency" short selling restrictions that were implemented this week. These remove the exemption for option market makers from the short-selling locate rules. It is our belief that this will result in option markets trading at significantly wider spreads and hence "artificially" increase the cost of premium, which would in turn be reflected in the measure of the VXO. Rushed legislation of this type is rarely effective (see our comment earlier today on EM measures) but can have severe unintended consequences. Seeing the VXO soar to 60 was presumably not what the SEC was hoping for when it hurriedly drafted these clumsy rules.

China to Scrap Stamp Duty, Purchase Bank Shares, Xinhua Says

As EM markets have collapsed globally, we have seen a steady stream of interventionist measures by local authorities. Pakistan has banned its local index (KSE100) from trading below its August 27th low, Taiwan announced last night it is considering to purchase local equities with state funds, Russia announced an aggressive plan this morning and now the Chinese authorities are joining the fray.

No doubt Hong Kong, which supported its own market in August 1998, is being held up as the example to follow. That particular policy was wildly successful and the HSI rose 68% in the 3 months following its introduction and 119% by the following June. On the other hand, that recovery took place against the backdrop of a booming economy and the greatest global equity bull-market since the late 1920's. This time, EM equities face rapidly worsening economic fundamentals and global ownership at an unprecedented level. While in the short term, an emergency package may staunch the flow or simply make it illegal as in Pakistan, we very much doubt if they will have more than a temporary effect. Still they will make playing the short side that much more difficult in the weeks ahead. We do expect the EM complex to put in a low sometime around the end of the quarter but remain convinced that any prolonged rally should be used to aggressively cut exposure.

Unbelievable and a sign of the total flight from money market products. Interestingly, T-bill rate actually went negative in 1938 and 1939 and this could yet occur today.

The combination of financial sector turmoil and the consequent historic news that the Reserve Money Market has "broken the buck" has led to a remarkable series of moves in fixed income markets this morning. Attached are 3 charts that should all be familiar demonstrating this:

(1) The 5-Year Swap and Agency chart. Note that 5-year swaps are back towards the high end of "crisis" territory while GSE spreads are far higher than they should be following the announcement of Conservatorship. Our conclusion is that an element of forced liquidation is taking place.

(2) 3-Month T-Bill with FDTR. Hardly surprisingly, T-bill has been driven down to a record low as participants flee Money Market products for the guaranteed principal available in T-Bills. Even so, we do not believe that any Money Market Fund controlled by a major bank for the use of its retail depositors will be allowed to "break the buck".

(3) US, UK, ECB 3-month Libor rates (nominal yields). Note that the US 3-month Libor rate has broken out for the first time since April.

Far from being decoupled, it is becoming increasingly apparent that EM is actually hyper-sensitive to the change in risk parameters in US financial markets. This may not be a surprise to us but it is a rude awakening to many others.

Note comments on lack of financing available since LEH's demise over the weekend. As we commented at the time, LEH was a key provider of commercial RE credit - it is doubtful that anyone else is going to be willing to fill that void.

Lehman New York City Headquarters Tower May Be Worth $1 Billion

As we have said, the LEH bankruptcy has very negative implications for the commercial RE market.

3-month yields collapsed to as low as 65 bp today and are currently 82 bp. We are clearly in full "flight to safety" mode. Note the BSC low point for the 3-month T-Bill yield was 38 bp. We would assume that a good portion of today's plunge can be linked to participants trying to unwind exposure to institutions whose survival is now a cause for concern. Note that back in March, things came to a head quite quickly once yields fell below 1.00% and whatever the outcome, we would look for another dramatic event in the coming sessions.

Criterion Diversified Commodities Fund to Move to Cash

Very interesting. This suggests that the problem at AIG may result in direct pressure to the commodity complex as commodity swaps are unwound. Helps explain crude's sudden collapse in early trading.

The abrupt change in policy by the Treasury and FRB was clearly designed to address the growing issue with "Moral Hazard" - unfortunately it only really deals with the first of these words. It is not clear that they anticipated the result of their hardened stance although they clearly were prepared to accept this eventuality.

While losing Lehman is a genuine shock to the global brokerage environment, there is no obvious service that they provided with the exception of commercial real estate credit issuance that cannot be adequately replaced by other global broker dealers.

Clearly this shock from the liquidation of LEH is somewhat compensated by the merger of MER/BAC. To read the full commentary, click here.

The VXO index is well into the "panic" zone this afternoon with a reading of 30.48 at the current time. This is somewhat surprising given that although the SPX is close to its July low, it is not in imminent danger of breaking down and is down well under 1% today and up a fraction on the week. The other times that the VXO has risen above 30 in recent months have coincided with the broad equity market falling rapidly to register new lows. Even within the financial sector, weakness is limited to the specific troubled companies that are on everyone's radar screens and the BKX index is actually slightly up on the day.

None of this would seem worthy of a VXO reading well above the 27.5 panic line. The only explanation that we can think of is that people have become well attuned to the possibility of a "Sunday Surprise" and that participants are willing to "overpay" for put protection ahead of the weekend. Another indication of the highly unusual nature of the current market.

Despite continued turmoil in the capital markets, at the end of the day the GSE rescue has achieved its primary goal - lower interest rates for homeowners.

As commodity, currency and equity markets continue to exhibit extreme stress, we are starting to see the phrase "flight to safety" appear more and more regularly on our screens. It is therefore interesting to note that the safest of all assets, the 3-month US T-Bill currently shows limited amounts of panic buying. The chart below shows that at the height of the BSC crisis, T-Bills fell to 38 bp, a remarkably low yield that reflected the concern that BSC's failure would trigger multiple counter-party defaults. The mid-July GSE panic was milder, but still saw yields fall to 1.25%. As of this morning, T-Bills are yielding 1.57%, which is still a large discount to the FDTR (black line on chart) but not yet a true "panic" reading.

We would interpret this chart in two ways. Firstly, the current sell-off has yet to reach its crescendo and yields may well decline in the coming days to reach a "panic" level" (1.25% or below). Secondly, the organized rescue of BSC and the GSEs has substantially removed the "worst case scenario" of a collapsing global financial system and replaced it with a sclerotic, expensive recovery process, but a recovery process nonetheless. As such, there is really no need to invest in T-bills irrespective of yield (as was the case in March), provided the safety net of government intervention remains in place. Should this be taken away (highly unlikely in our opinion), all bets would be off.

By Shannon D. Harrington
Sept. 11 (Bloomberg) -- Concern that Lehman Brothers Holdings Inc. may not weather the credit turmoil have failed to trigger the same kind of market-wide panic that preceded the collapse of Bear Stearns Cos., trading in credit-default swaps on the biggest securities firms shows.
The CHART OF THE DAY shows credit-default swaps protecting against a Lehman default soared to a record yesterday even as Merrill contracts fell, Goldman closed 77 basis points below its March peak and Morgan Stanley was more than 110 basis points below its high. In the days leading up to Bear Stearns's collapse on March 14, the credit swaps on all of the brokers jumped to a record.
"One of the interesting things about Lehman versus Bear Stearns is that the world is being much more patient," said Michael Shaoul, chief executive officer of Oscar Gruss & Son Inc., a New York-based brokerage. "People aren't going home at night and saying, Is there going to be a counterparty failure across the street? There's a sort of willingness to trust the system to find a solution."
Lehman also remains well below the record Bear reached two days before the Federal Reserve backed an emergency sale of the firm to JPMorgan Chase & Co. partly to avoid a wave of losses across derivatives markets. As market-makers, both Bear Stearns and Lehman have been among the top 10 counterparties to credit- default swaps trades, according to rankings by Fitch Ratings.
Credit-default swaps on Lehman soared to a record 610 basis points yesterday, according to broker Phoenix Partners Group, about 200 basis points below Bear Stearns's peak before its emergency sale to JPMorgan Chase & Co.
"The lesson from Bear Stearns is that the bondholder was made good," Shaoul said. "It's questionable whether the authorities are willing to let a large broker-dealer actually go through a bankruptcy with all the counterparty implications that come with that."

Lehman No Bear Stearns as Money Markets Show No Panic

Longer version of yesterday's story - includes details of calm in money markets - see yesterday's 3-month T-Bill chart.

The EUR/JPY cross rate is very much the "senior" carry trade and as such has offered a useful window into the level of stress not only in currency markets but also (by extension) into general HF allocation during recent periods of turbulence. As the chart below shows, the round number of 150Y has been key support since late 2006 and the market panics of February & August 2007 and March 2008 all failed to pierce this level. It is therefore interesting that the current sell-off has extended through this key support. Note that the all time high for this cross rate was recorded in the first weeks of the 3rd quarter (coinciding with the top in commodity markets and the recovery of the USD) and that the subsequent collapse in this cross rate has been brutal.

Key support at 150 was tested last week and held, leading to a bounce all the way up to 157 on September 7th. The cross then fell straight back down and broke through the 150 level yesterday evening and is currently at 148.91. MACD demonstrates a level of downward momentum out of character from anything we have seen before. Clearly this move is "overdone" but equally clearly we are in the middle of a "multiple-sigma" scenario where the normal rules do not apply until the liquidation has run its course. As such, the EUR/JPY cross will act as a useful indicator and should be followed accordingly.

With all the brouhaha over LEH and WM, it is easy to forget about crude oil, but the price of this commodity is probably far more relevant to emerging market and commodity-related equities than the final details of these two companies' demise.

Crude quietly tested key support at $100 this morning with barely a whisper of attention. This key round number seems to be relied upon to automatically halt the powerful two-month decline in crude, and this alone makes us suspicious that it will fail to do so. We would expect the first two or three assaults to be repelled but with three more weeks of September to run and redemption pressures expected to intensify towards month end, the chances of a break below $100 would seem to be reasonably high.

Should this occur, it would almost certainly accelerate comfortably below this level, with little obvious support remaining above the February 2008 low just above $85. We are aware that this appears to be an aggressive target but these remain exceptionally unusual times.

Russia continues to be the epicenter of the current violent correction in emerging markets. As the logarithmic chart of the RTSI$ Index shows below, this benchmark index for foreign investors has collapsed in recent days and at its current price of 1318.63, it is not too far away from fulfilling our "worst case scenario" for the current sell-off, which was a full retest of the June 2006 low (marked with blue line). This level comes in at 1218.23, or about 8% below the current index price, which is in effect "touching distance" for an index capable of losing 5%+ in a single session.

With losses from the recent all time high now reaching 47% of peak value, this sell-off goes down as one of the quickest and most brutal for any major market. While we would expect the index to establish a defendable low in the relatively near term and would not be surprised to see a spirited recovery once this occurs, any such recovery would be a selling opportunity for holders still exposed to this market.

While the index is currently deeply oversold on a short-term basis, a longer-term chart such as the one below shows that the index is still some distance above what may prove to be the eventual resting point of what we anticipate will be a 2- to 3-year bear market. This is marked by the pink band on the chart and represents the "launch area" of the 3-year parabolic rally that commenced in June 2005.

WaMu Shares Reach Lowest Since 1990, Debt Risk Surges, Bloomberg.com, September 10, 2008

While all the focus is on Lehman, WaMu seems much more likely to be facing an imminent demise. We would not be surprised to see an FDIC bailout in the near future.

Interesting - suggests that the Gulf RE market (pretty much the last man standing in residential RE development) is cooling quickly. Clearly another negative sign for steel consumption in general.

September 8, 2008
Topic: Capital Market Implications of GSE Conservatorship

An audio replay of Michael Shaoul's conference call regarding the bailout of Fannie Mae and Freddie Mac.

Audio replay: right-click and choose "Save Link As" to download.

Brazil continues to suffer from the intense selling pressure visible on all emerging markets. The IBOV index broke down below "round number" support at 50,000 this morning and the index seems likely to test support at 45,000 & August 2008 low in the near term, a fall of almost 10% from the current level. Note that the overall MSCI EM index fell below its own August 2008 low early last week and has continued to lose ground in recent days.

Against a backdrop of a GSE rescue and ongoing fears that institutions such as LEH and WM may not survive, it comes as little surprise that money should be seeking a safe haven in the Treasury market. Nevertheless the performance of 30-year bonds is remarkably strong in both nominal and "real" (i.e. CPI adjusted) terms.

Looking at nominal yields first, we see that at 4.20% they are within 10 bp of the multi-decade low recorded in January 2008 and just above the level recorded at the height of the BSC crisis, which may seem fair enough given the scale of financial problems that are currently being discussed. However, when one considers "real" yields (lower chart), we can see that something more remarkable is going on. CPI has risen considerably since the early part of 2008 and the current "real" 30 year yield of -1.40% is the lowest recorded since at least 1980 (when our price feed from Bloomberg commences).

While it is quite possible that yields will fall further in the coming days, and we would not bet against a new nominal low (i.e. below 4.10%) being recorded, it is hard to believe that 30-year bonds represent good value on anything other than a trading basis at the current time. We would expect to see nominal yields move substantially higher once the current period of disturbance has abated. The adjustment of "real" yields on the other hand may also come from headline CPI dropping sharply in the months ahead as commodity input prices continue to correct sharply.

As we anticipated, the USD has rallied strongly against major currencies as the implications of the GSE bailout become apparent. A good portion of this move is simply "mechanical" and derives from a release of pent-up demand for Agency paper from non-US institutions. It is clear that this demand has not (thus far) come at the expense of demand for US Treasuries which remain well bid.

Looking at the ER/USD cross, we can see that this rate is falling within range of important "round number" support at 1.40. Note that MACD (lower chart) has turned sharply lower and recorded a new low that confirms the validity of the sell-off. Interesting the cross rate also just crossed the 500 day moving average, our favored simple definition of the transition from "bull" to "bear" market. While support at 1.40 may hold in the immediate future, it seems likely that the USD will continue to make gains against the EUR in the weeks ahead.

Following the announcement of the conservatorship of the GSEs, both Agency and Swap spreads are trading significantly tighter. 5-year Agency spreads (bottom chart) have fallen to 62.8 bp, a drop of approximately 31 bp from Friday's level and about 55 bp from their August high. Since 5-year Treasury note yields have only risen by 10 bp, the bulk of this spread tightening has been effectively transmitted to lower nominal Agency yields. At 3.64%, the 5-year FNMA note is now yielding approximately 100 bp less than it was in June and 70 bp less than it was in August. Outside of institutions that hold the senior and subordinated debt, the big winners from the weekend's developments seem to be the homebuilders who will now be operating in an environment with sharply lower mortgage costs. We would look to purchase both homebuilder equity and senior debt at the current time.

Swap spreads have also collapsed and have fallen to 84 bp just below the 85 level that we use to indicate a "stressed" environment. While this package in no way marks the end of the current crisis, it does close one of the more troubling chapters. Once more the US authorities have shown a determination to protect the viability of the local financial system in direct contrast to the confused response of other administrations (notably the ECB and BOE). No matter the sizeable direct costs of this action for the US Treasury, the implications of this resolve strike us as uniformly positive for the USD going forward.

After rallying strongly on Friday afternoon/Monday morning, this index is back testing key support at 500. Chance of a breakdown looks quite high.

While much of this morning's euphoria has rapidly dissipated and even turned to losses in the commodity complex, the homebuilder sector stands out as the one to hold onto the bulk of its gains. This makes good sense since it is clear that one way or another the Treasury, FRB and Congress are determined to ensure that the residential mortgage market offers consumers access to loans at lower rates than have been available in recent months and this in itself has to be of benefit to the homebuilder sector. Looking at the chart, today's breakout suggests that the way is clear for the index to rally up to strong resistance around the 375 level, a gain of just over 10% from the current level. As we have stated before, homebuilder equity and debt remain attractive at the current time.

Paulson Statement on U.S. Action on Fannie, Freddie: Text, Bloomberg.com, September 7, 2008

Pretty much as expected. Treasury will purchase new senior preferred securities as required to do so. Existing common and preferred stock continues to exist but all dividends cancelled and they will bear first losses - we would expect them to trade at severely discounted levels starting Monday. More importantly, Paulson reiterated the need for the GSEs to proactively stabilize housing market and all capital constraints on growth have been removed. In a further move to collapse agency spreads, Treasury will step in and purchase Agency paper directly from new issuance (amount to be announced later) - note this is something we have advocated for several weeks - if you are going to put the US balance sheet in the way of potential capital losses, you might as well pick up the spread on offer in the capital market. Perhaps the only surprise is the decision to place the Treasuries new senior preferred BEHIND the existing subordinated-debt of the GSEs - one could argue that junior debt holders should not receive the same protection as holders of true agency paper since the "implicit" guarantee was never supposed to cover this paper. In all likelihood, the Treasury is aware that several significant financial institutions hold large amounts of GSE sub-debt at the current time and did not wish to increase pressure upon such holders. Holders of sub-debt are therefore clear winners out of today's announcement.

In summary, we would expect Agency paper to trade at much tighter spreads on Monday, sub-debt to rally strongly, preferred and common equity to lose most of their value. Financial stocks (other than concentrated holders of preferred & common) should rally strongly, as should homebuilders.

While the meltdown in Russia has been getting the bulk of our attention, it should be noted that the other large commodity-dominated emerging markets have also been performing very poorly. Clearly none is more important in terms of capital allocation than Brazil and the benchmark IBOV is shown on the chart below.

After peaking in late May at 73,444 the IBOV lost approximately 27% by mid-August, falling to test support at the January 2008 low just below 53,000. A brief recovery rally then developed which saw the index rally over 7% in a few sessions before the downward trend re-exerted itself forcefully. In yesterday's session, support failed to hold and the index has fallen further to test "round number" support at 50,000. We do not expect the latter to hold but would instead look for a full test of the August 2007 low at 44,937; this target could be reached in a relatively short period of time.

Should this prove correct, the IBOV would have lost over 38% of its peak value, with additional losses for USD investors coming from the local currencies depreciation. At this level, the index would be deeply oversold potentially able to mount a reasonable recovery rally but we would not consider "bottom fishing" at the current time.

Copper has been under pressure for several weeks and during this time there has been a steady build up in LME warehouse stocks of the metal. Today saw the latter increase by 18,775 (almost 10%), the largest one day rise for four years. More importantly, it took stocks above the important 200K tonne level for the first time since January. The chart below shows stocks with a 60-day ROC measured in actual tonnes (lower chart). As this chart demonstrates, copper stocks have risen to this level on two previous occasions in recent years and then abruptly subsided. The current 60-day ROC (80K tonnes) is also roughly equivalent to the rate of increase seen in late 2006 and 2007. Should stocks continue to build beyond these levels in the following weeks, we would have an interesting piece of anecdotal data that would be supportive of a general moderation of copper (and by extrapolation commodity) usership.

It should be noted that current stockpiles are still extremely low on a historical basis. The 10-year average is 415K (roughly twice the current level) and peak stocks were recorded in May 2002 at 980K. However the VALUE of the latter (stocks multiplied by copper price) was $1.595 bln., not much higher than the current value of stockpiles of $1.400. There is therefore an excellent chance that the value of LME warehouse stocks will make a new record high in the coming weeks.

The AMEX Oil Index (XOI) broke down below support at 1250 today and is now testing support at the January 2008 low just above 1200. Below 1200 there is little further support until 1100. Note that the 500 day moving average (red line) has now been definitively violated, our favored definition of the transition from a bull to bear market. Should the index break down to new lows before the SPX violates its July low, this would be the first time that the energy sector had led the entire market lower for several years, a further indication that leadership has shifted during this difficult summer. The relative line vs. the SPX (green on lower chart) demonstrates the degree of underperformance that has been experienced in recent weeks.

U.K. August Car Sales Lowest Since 1966 on Fuel Prices, Economy, Bloomberg.com, September 4, 2008

While we are somewhat hardened in our view that the UK economy is under great duress, this piece of data still gave us pause for thought and the intransigence shown by the BOE in holding rates at their current level is unlikely to be treated kindly by history. More importantly, this story is a reminder that demand for basic materials and energy is proving to be elastic in both directions, much to the surprise of many market participants and commentators.

As the sell-off in emerging markets and commodity-related equities has gathered in intensity, we are starting to see clear signs of a flight to safety emerging in the Treasury market. This is most obvious at the long end of the curve and 10-year yields fell decisively below key support at 3.80% on Tuesday. Since breaking support yields have moved rapidly lower (as we suspected would occur) and are now testing support at 3.60%, a fall below 3.60% would imply that a level of panic/forced unwinding is taking place since it is hard to make any sort of a fundamental argument as to why 10-year notes are attractive at these levels. Other maturities show a similar sharp move downwards with 5-year yields falling below support at 3.00% to 2.88%, and 2-year yields now at 2.20%, 5bp below the FDTR.

To complicate matters, non-farm payroll data is due to be announced tomorrow and an unexpectedly strong reading (consensus is looking for -75K) would still have the power to reverse this move lower but when you consider the move in tresuries in conjunction with the dramatic reversal in portions of the global equity market, it appears as if we have entered the terminal phase of the current sell-off.

No sub-sector received more plaudits or positive inflows in the 2nd quarter than Agribusiness but this unanimous belief in the sector's fundamentals has proved to be of no help in the face of this summer's sell-off. Looking at the DXAG, we can see the highly technical manner in which this sell-off has advanced (always a sure sign that capital allocations are shifting rather than fundamental drivers), with support coming in at the 200 day moving average (green line upper chart) and several "round numbers" along the way, particularly at 575 and 550. We would suspect that structures (or put sales) written against this index at round number strike prices largely account for the support and subsequent acceleration once overwhelmed.

The index is now testing the crucial 500 level which combines the November 2007 and January 2008 lows and the 500 day moving average (currently 490). If support fails, we would look for significant follow-through with 450 a reasonable short-term target. Nevertheless, even if support holds and the index recovers, the 30% decline from the June 18th peak has signalled the end of easy money in this sector. Whenever the recovery rally does finally occur, it will represent a "must take" selling opportunity for those still holding onto positions in this sector.

Ospraie to Close Flagship Hedge Fund After 38% Loss, Bloomberg.com, September 3, 2008

The first high profile victim of the violent 3rd quarter correction in commodities and emerging markets. We do not expect it to be the last. The fascinating aspect of the current debacle is that these losses are unfolding against a relatively benign equity market. As we have commented before, the aggressive style of thematic investing that has dominated capital markets over the last 2-3 years is going to come under intense scrutiny in the weeks ahead and a return to a more prosaic investment style seems inevitable.

The MSCI EM Index (MXEF) closed below its August 2007 low (1st red line on chart) yesterday. So far, most EM markets are down today which will confirm the breakdown has follow through. The next clear support level comes in at the March 2007 low which comes in just below 842, almost 10% below the current level.

The DXY Index has succeeded in breaking through key resistance at 78 in the overnight session. While we are naturally cautious of any move that takes place while the US market sleeps (particularly after a US holiday), this technical achievement is notable enough to get our attention. It has been apparent for several weeks that the USD was enjoying something more than a "dead cat" bounce. If the DXY can sustain its move through 78, this would suggest that considerable further gains can be anticipated in the weeks ahead. Shorter term, we note that 79.07 would represent a 38.2% Fibonacci retracement of the Nov 2005 - Mar 2008 sell-off, and this therefore marks the next obvious resistance point above 78.

We continue to see USD strength as a major positive for US equity markets since we believe that its effect on stimulating foreign investment flows will far outweigh the reduction of exporters' profitability. The opposite can be said of many "alternative" investment strategies and, given the appalling 3rd quarter that many HF's have been experiencing, a further USD breakout combined with weaker commodity prices seems likely to claim some high-profile victims.

Following the failure of Hurricane Gustav to wreak havoc in the Gulf, there has been an abrupt collapse in energy prices (crude oil and natural gas are both down 7% from Friday's close). While these moves are exaggerated by the Labor Day holiday (energy markets were open on Sunday but trades will be reported "as of" September 2nd), this still represents a major breakdown. Crude oil has smashed through key support at its 200 day moving average and the $110 level and if prices do not recover quickly (we do not expect them to do so), then crude will be targeting the big round number at $100. Natural gas has been weak for some time but today's losses actually take gas down on the year. Given the large concentrated positions which some funds had taken late in the 2nd quarter, it is likely that there is an element of forced liquidation in today's markets.

Outside of energy, commodity prices are generally weak. Gold and copper are down over 1.5% while corn (in a light overnight market) is down over 4%. It should come as little surprise that we would happily remain short equities connected to energy, materials and agriculture at the current time.