A clear pull back in risk appetite was apparent at the start of this trading week. The catalyst was the lack of action by policymakers despite plenty of hype and anticipation of a strong guiding hand. Once again, European policymakers failed to grasp the severity of the current crisis. I guess that what happens when academic economists hand civil servants an innovative economic union to enact.

The currency wars continued to heat up on Friday with Poland entering the fray with an FX intervention. The massive flight to quality has taken its toll on the Zloty and sovereign bonds and Polish authorities attempted to smooth the stark erosion of value. In Switzerland, SNB Chairman Hildebrand stated the SNB would enforce the exchange rate cap with all consequences, adding fuel to speculation that the Swiss central bank might raise the EURCHF floor to 1.2500. While in Japan, Finance Minister Jun Azumi offered a fig leaf to Europe by saying that Japan was ready of provide support to Europe, potentially in the form of buying EFSF bonds. He then added that the sharp rise in JPY continued to hurt the Japanese economy - delicately linking the two issues.

The IMF provided a communiqué stating the global economy had migrated into a dangerous phase, calling for exceptional vigilance, but provided little in terms of solutions. EURUSD traded down to 1.3363 from 1.3583 while AUDUSD fell to 0.9637 from 0.9866. Asian regional indices were broadly lower as the Hang Seng fell -3.04% and Nikkei slid -2.17%. Interestingly, precious metals continue to fall with silver dropping swiftly in the last three day to $26.07 and Gold to $1567.50, suggesting that external risk reduction is now forcing traders to liquidate historically safe-haven sides of their portfolio. More interesting, is that the divergence between CNY and CHY continues to make itself noticed, as the appreciation of the onshore Yuan has not been followed by an offshore instrument, potential illustrating that investors have become doubtful that China will be able to come out of the economic downturn unscathed.

Over the weekend there was considerable sable rattling from Germany. With growing evidence that political support for Merkel and her party is facing significant erosion due to actions around the European sovereign debt crisis and deteriorating domestic economic conditions, the general tone has shifted. German Chancellor Merkel stated on Sunday that it is possible to see a sovereign default in the Eurozone yet such an event would destroy confidence in the Economic union. German deputy Finance Minister Asmussen provided more confidence-eroding comments by suggesting that the next tranche of aid to Greece is not certain and markets should not expect that the Eurogroup will have a quick and easy decision on Oct 3rd.

In Greece, local media continued to suggest that Germany is spearheading a default plan that would include a 50% haircut to bondholders. To add to the overall confusion, the ECB's Mersch stated this morning that expectation of a near term ECB rate cut were unrealistic and he referred to the central bank's mandate of price stability adding that they had one needle in the compass. Yet ECB Governing Council member Nowotny (reiterating the concern of ECB Executive Board member Stark) commented this weekend that the ECB growth forecast could be lower given the recent events in the Eurozone and beyond.

The weekend's discussion in Washington continued to revolve around the EFSF leverage and plan for recapitalizing Eurozone banks. Both issues would take significant resources and approval from every country's underlying parliament and as such - this has damped our expectation of either any time soon. We will continue to fade risk rallies.

In regard to the EFSF comments over the potential of leveraged to be used to expand the fund's firepower (and idea suggested by Geithner) - given the diverse comments and media reports, there is clearly a conversation regarding the possibility. However, EFSF CEO Regling took some wind out of expectations saying that it would be highly unlikely that leverage would be employed by the EFSF (lending stands at €440bn). Regling went on to say that there are other ways to maximize the EFSF's resources.
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