The Final Capitulation?

In last week's report, I held out the prospect that the US government rescue package might result in a change in sentiment in financial markets, and signal the start of the healing process. I also noted, "The major risk to this outlook is that I am premature and there is a final spasm of market pessimism, resulting in a capitulation collapse across asset classes." Unfortunately, my timing was off, and the latter outlook proved to be the case well beyond my worst nightmares. But in this process, there are many rays of hope.

One of the contrarian indicators that suggest a market is in the process of bottoming is a final plunge, usually driven by panic selling emanating from emotionally ravaged investors. Such was certainly the case this week, culminating on Thursday and Friday with massive declines. But on Friday, the collapse was not sustained and US stock exchanges managed to finish near flat on the day.

One of the other indicators of a market bottom is just such a day's price action, best symbolized as a 'star' on daily candlestick charts. The long tail at the bottom represents the final wave of selling, which was ultimately reversed by new buying entering the market. While I run the risk of being premature again, I remain optimistic that this was indeed a key reversal day.

Lost in the panic this week were the novel steps taken by global central banks to address the credit market freeze, and limit its impact on their non-financial, 'real' economies. Among these are the Fed's decisions to buy commercial paper directly from firms; lend directly to non-financial companies shut off from normal credit; double the size of the TAF auctions to provide further liquidity to banks; pay interest to banks on reserves held at the Fed; and orchestrate a global rate cut. Many of these efforts still need to be fully implemented, but they are coming.

Most important appears to be the idea of using some of the $700 bio rescue package to inject capital directly into banks (see below). Other central banks are taking similarly aggressive and proactive measures, including guaranteeing inter-bank lending and bank deposits, as well as making capital injections directly into banks. Additional measures are likely to be announced over the weekend, as the G7 and G20 are set to convene along with the IMF/World Bank regular meeting. Additionally, Eurozone leaders are set to meet in Paris on Sunday to develop Europe- specific policies to address banking sector strains. That leaves us still waiting for signs of concrete change, rather than just relying on talk, which is what sent markets plummeting this week.

Still, I think stocks are more likely to stabilize rather than continue to plunge, but that risk is still out there. I'll be keeping an eye on the same barometers of credit conditions outlined in last week's report. Of those, I would note that gold plunged today, despite fear remaining palpable.

Outlook for currencies during the turmoil.

While we wait to see how government steps to stabilize the banking sector play out, and how markets react, there are two main drivers in the Forex market.

The first is fear and risk aversion, which characterized this week's price action. During such panic driven turmoil, the JPY strengthens across the board, and JPY-crosses (e.g. AUD/JPY, GBP/JPY, EUR/JPY, and CAD/JPY) plunge. Such cross selling pressure weighs on other dollar pairs, sending GBP/USD, EUR/USD, and AUD/USD lower and this is frequently viewed as USD strength. As fear abates, and stock indexes recover, the JPY is sold and the JPY-crosses move higher. The other main driver is, in fact, heightened demand for USD, and this stems from two main sources.

First, as investors flee other asset classes, whether stocks or commodities, they seek the safest investments, primarily US Treasury securities, which require USD to purchase. The second source of USD demand stems from credit market demand for USD spilling into the currency market. When markets begin to stabilize and credit conditions start to normalize, I expect demand for USD to diminish rather abruptly. Hopefully, it's clear that more stable markets will lead to higher JPY-crosses, and a lower USD. Lastly, there is economic data, which was completely overlooked in this past week. Next week however, a trove of significant US data awaits and it is not expected to be USD friendly.

While there are no guarantees that such stabilization will emerge, and traders will need to remain extremely flexible, I am optimistic that we have made a key low in the JPY-crosses, and a likely peak in the USD. USD/JPY and the JPY-crosses, show similar bottoming patterns on Friday's daily candlestick charts, namely 'stars' and 'hammers.' Reversal signals are less evident in other USD pairs, with the exception GBP/USD, which presents a likely hammer. I would now look to start buying GBP/JPY, AUD/JPY, and EUR/JPY on dips into lows seen this week. In the USD pairs, I would look to buy GBP/USD and EUR/USD on weakness into the 1.6850/6900 and 1.3250/3300 area, respectively. Strength over 1.7200 and 1.3550 likely signals those pairs are set to move directly higher.

The last best hope—direct capital infusions to banks.

With the latest attempts to instill confidence in US financial markets (passage of the TARP and Fed rate cuts) failing miserably for now, the US Treasury may attempt direct capital infusions by potentially acquiring preferred stock in banks. Ostensibly, Treasury Secretary Paulson and some of his top aides are looking into this and may begin buying stakes in banks within the next few weeks.

With the TARP plan, the government wipes a bad asset (toxic mortgage) from the banks' balance sheets, but only adds to its capital if it pays more than what the bank has already marked that asset down to. This would then leave those banks, in a position to seek capital from outside sources in order to bolster their balance sheet. In the case of the capital infusion, however, the banks' balance sheets would be instantly repaired.

This would of course come at the expense of current shareholders, who would suffer dilution as a result of the government's participation. However, the planned $200 billion infusion (using funds from the appropriated $700 billion in the TARP), would likely fully re-capitalize the US financial system. Credit market losses in the US are currently running at just over $380 billion, with only $220 billion in capital raised as an offset. This leaves a $160 billion gap that would be instantly filled with the proposed $200 billion infusion, and would provide a good cushion to the system.

In terms of the credit markets, this should limit the counter party risk drastically as newly capitalized banks would be less likely to default. Credit spreads would come in from recently astronomical levels, and capital would likely begin to flow more freely. This would in turn likely see the recent pessimism in the stock market reverse and send equities markedly higher. The G7 members are purportedly throwing this idea around in terms of applying it in other countries as well, which would be a welcomed sign for global markets.

Key data and events to watch next week.

The US calendar next week is packed with top-tier economic data. Tuesday starts things off with the monthly budget statement. Wednesday has producer prices, retail sales, and the NY Empire manufacturing index due up. Thursday is even busier with consumer prices, initial jobless claims, capital flows, industrial production, Philly Fed manufacturing index, and the NAHB homebuilder confidence index. Housing starts, building permits, and the University of Michigan sentiment index, round out the week on Friday. There are also 11 Fed speakers next week with Fed Chairman Bernanke, and Fed Vice Chairman Kohn on Wednesday, as the highlights. Look for the Fed's latest Beige Book on Wednesday as well.

The Euro-zone calendar is a touch less eventful. French business confidence, French consumer prices, Euro-zone ZEW, German ZEW, and Euro-zone industrial production all kick off the week on Tuesday. Wednesday follows with German and Euro-zone consumer prices, while Friday rounds out the week with the Euro-zone trade balance. ECB President Trichet is due to speak on Tuesday, and German Finance Minister Steinbrueck is up on Thursday. Also look for a EU leaders' summit on Wednesday.

Japan's economic calendar is modestly busy and kicks off with domestic CGPI on Monday. Consumer confidence, the current account and trade balance, are due on Tuesday. Wednesday has industrial production on tap while Thursday sees the Tertiary industry index. Nationwide department store sales and a speech by the BOJ's Shirakawa close the week out on Friday.

The calendar in the UK is on the light side. Producer prices and RICS home prices start the action on Monday. Tuesday has retail and consumer prices due up, while Wednesday has the all-important employment report on tap. Also watch for a speech by the BOE's Sentance on Monday.

Canada is ultra light in terms of economic data with only manufacturing shipments on Thursday. The Canadian election will be the main focus on Tuesday, with Canadian Prime Minister Stephen Harper still leading in the polls.

It is relatively quiet down under as well. New Zealand retail sales kick off the week on Sunday evening. Tuesday then sees Australian business confidence. Wednesday has New Zealand business PMI and the Australian leading index on tap. Last but not least, look for Australian import and export prices on Friday.

By Brian Dolan of Forex.com