Stocks Rally and Currencies Recover: Is this the Bottom?

The case for a bounce in equities this week was strong following the Lehman CDS Auction and the possibility of new measures from the G7 and G20 nations in Washington this weekend. New guarantees and a host of other announcements have helped to stabilize the financial markets and ease the credit crisis, but is this enough or are we simply seeing a light volume Columbus Day rally in US equities?

Banks and money markets are closed today, which means that we have yet to see the full reaction to this weekend’s announcements, but there is a good chance that this is a near term bottom that could lead to a move back above 9500 in the Dow as investors come in to scoop up stocks at fire sale prices.

Many of the liquidity problems in the financial markets have been addressed by the unified response from the G7 nations. The timing is also right because equities and carry trades have become so oversold leading investors to look for a reason to buy. Sentiment is extremely important these days and we have seen market sentiment shift from skepticism to hope, which should lead to a reversal in the strength in the US dollar and Japanese Yen. From the unlimited dollar funding to interbank loan guarantees, the efforts of nations around the world may be finally working.

In order for this to be the long term bottom in equities, two important hurdles need to be overcome – the Oct 21 settlement of Lehman’s Credit Default Swaps and the Nov 7 settlement of WaMu’s CDS. As counterparty A forks up payment to counterparty B for the protection of a Lehman default, bankruptcies is a strong possibility as those who fall into the counterparty A group fail to come up with the money. If there are no major bankruptcies that forces the US government to come up with another $100B to recapitalize an ailing financial institution, then the worst may be over (Here a great article on Who’s on the hook for the Lehman CDS mess).

Eventually everyone does the right thing and this is the step in the right direction for all of the major world economies. For the currency market, this means a correction in the US dollar and the Japanese Yen, but a recovery for carry trades and the Euro.

Now let’s get a little bit more specific on who announced what this weekend:

G7 Statement

There was no specific details in the G7 statement, but the nations pledged to:

1) Ensure liquidity in interbank lending
2) Not allow systemically important financial institutions to fail
3) Ensure that the banking sector is well capitalized

Individual announcements were made following the G7 announcement that basically guaranteed lending 3 to 5 years out in the hopes of reducing the fear of counterparty risk.

US: The US announced that they will offer unlimited borrowing along with the BoE, ECB, SNB. There will be a fixed interest rate, erasing any uncertainty and the size of the swap lines will be increased to accommodate whatever dollar funding demand is needed. The markets are still waiting for details on the new plan to take equity stakes in financial firms, “among other points.”

Interim Assistant Secretary for Financial Stability Neel Kashkari said that nothing will come today because of the Columbus Holiday, but they are suggesting a multiprong approach.

What the Treasury did outline was further details of the TARP plan which will include the following. Custodian and asset managers should be over the next few days. More detail equals more confidence for the markets today:

1) MBS Purchases
2) Whole Loan Purchases
3) Asset Insurance
4) Equity Purchases
5) Homeownership Support
6) Executive Compensation Rules
7) Oversight

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EU – EU leaders agreed to guarantee new bank debt and to keep distressed lenders afloat. Their cohesive pledge of action has been very positive for the euro. More specifically, Germany announced EUR400B in loan guarantees (the equivalent of US$680B) while France is expected to announce similar measures.

UK – The British government essentially nationalized RBS, Lloyds/HBOS by injecting $64B into the banks to boost their capital and market liquidity. Their measures are aimed at reducing the risk of liquidity problems turning into a bankruptcy by any of these banks. In doing so, it will reduce counterparty risk which is why the British pound has soared on the announcement.

Australia – Announced that they will guarantee all deposits with financial institutions over the next 3 years and bank lending

New Zealand and U.A.E – Will guarantee retail deposits

From the WSJ

From the WSJ

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