The main themes dominating the markets today is the weakness of the US economy and the threat to the global banking sector after French, Italian and US banks hit the skids yesterday. This is weighing on stock markets and has fuelled a flight from risk.

Main themes:

  •  The Fed did what was expected of it and announced two measures to try and boost the economy. Firstly, it will purchase $400bn of securities with maturities of 6-30 years by the end of June 2012 with the proceeds of sales of securities of shorter dated maturities. The aim is to put downward pressure on long term interest rates, get people to re-finance their houses, put cash in their pockets that they can then spend, although consumption is a little out of fashion at the moment so it may not work as expected.
  •  The Fed surprised the markets by also announcing a plan to reinvest the principal payments from its holdings of mortgage-backed securities. But rather than concentrate on the policy response from the Fed, the markets have taken fright at the Fed's economic outlook which was decidedly negative on growth. This caused the S&P to close down by nearly 3% after the conclusion of the Fed meeting. The sell-off has continued into the European session, which has had a weak start. The FTSE is off nearly 1.5%, while the Eurostoxx is down nearly 2%.
  •  So why did the Fed's Twist fail to woo the markets? Firstly, it's down to the banking sector. Wells Fargo and Bank of America Merrill Lynch were downgraded yesterday, Italian banks were also downgraded and French banks sold off hard yesterday after the ECB announced that one bank (rumoured to be French) borrowed $500mn from it last week, suggesting that inter-bank lending conditions remains extremely tight. Banks earn money from borrowing short and lending long. If interest rates on longer-dated securities are being lowered then it follows that banks' earnings should be negatively affected. So, ironically, the Fed's Twist announcement could not have come at a worse time for the global banking sector and actually makes life a bit harder for the bankers.
  •  The yen and the dollar are the strongest currencies in recent weeks. This is no surprise - they are both safe havens. The dollar index is running into a little bit of resistance at 78.00, however, with stocks off and a banking crisis in the mix, it's hard to see much getting in the way of a stronger dollar.
  •  It's now over the ECB, and there is a growing consensus that Trichet - at his last meeting as Chairman in early October - may loosen monetary policy after two hikes this year, as the sovereign debt crisis escalates rapidly.
  •  The ECB has already announced that it is reducing collateral requirements to make it easier for banks to access funds. This hasn't eased fears for Europe's financial sector, and instead highlights how desperate the situation is for some banks.
  •  The Greek government said it would accelerate budget cuts (it's said that before).
  •  New Zealand GDP for Q2 was weaker than expected.
  •  The RBA's Battelino suggested that the markets might be going down the wrong track if they expect the Bank to cut rates any time soon, he said the Bank was keeping an open mind on policy.

Market reaction:

  •  The dollar had a storming session yesterday, however, it is taking a breather this morning. European PMI data could be the catalyst for another leg lower in the single currency, which could give the dollar another boost later on.
  •  The dollar's strength was broad based and is the major driver across asset classes today. The dollar is stronger against the yen, up from a low of 76.12 yesterday to a high of nearly 77.00 today. However, USDJPY might be the harder cross to trade if you are looking for dollar strength, since the BOJ seems fairly comfortable with yen strength for now.
  •  The euro is the weakest of the majors today as the pound finds some composure after yesterday's BOE-inspired sell-off. These two are likely to fight it out for the worst major performer while the dollar remains on a roll.
  •  The growth currencies - CAD, kiwi and AUD - are being dragged lower by growth fears, weaker commodities and a stronger dollar.
  •  The strong dollar is weighing on commodities. Brent crude had a major move to the downside, falling $1 at the European open, copper is fairly flat and gold is also lower as the dollar dominates things.

Ahead today, the European PMI's, the sovereign debt crisis and the performance of banking shares, in particular, should be the main focus.

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Kathleen Brooks| Research Director UK EMEA |

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