Forex Market Update: Financial Sector Woes Spreading To Europe As Modified US Bailout Plan Moves Forward. USD Up And EUR Down On The Weekend's Developments.

Key for markets now is whether frozen credit/money market shows any sign of improvement.

MAJOR HEADLINES

• New Zealand Aug. Trade Balance out at -750M vs. -926M expected
• Japan Aug. Retail Trade grew 0.7% vs. 0.2% expected

THEMES TO WATCH - UPCOMING SESSION

• UK Aug. Mortgage Approvals (0830)
• EuroZone Sep. Confidence Surveys (0900)
• US Aug. Personal Income/Spending (1230)
• US Aug. PCE Deflator (1230)
• New Zealand Aug. Building Permits (2145)
• UK Sep. GfK Consumer Confidence (2301)
• Japan Sep. Nomura/JMMA Manufacturing PMI (2315)
• Japan Aug. Jobless Rate (2330)
• Japan Aug. Household Spending (2330)
• Japan Aug. Industrial Production (2350)
• Australia Aug. Building Approvals (0130)
• Australia Aug. Retail Sales (0130)
• New Zealand Sep. NBNZ Business Confidence (0300)

Market Comments

Congress finally reached a deal on the bailout package, which now looks set to pass into law in the immediate future. There are many adjustments in the details, but the general idea is still that the government takes toxic assets off the bank's balance sheets with a $700 billion dollar purchase plan. The last minute counterproposals by House Republicans that threatened to end the entire bailout effort late last week were largely dropped.

The most important changes to the original plan involve heavier oversight from Congress (most likely a cumbersome task...) and a plan for the US govt. to receive equity stakes in the institutions it is helping to bail out. Part of the plan importantly makes provisions for reduction of payments and the amount owed on mortgages that have been bought by the US. This last point is very important for the eventual fate of the US consumer, as the enormous debt overhang in the US economy, and the likely shift in savings habits as US consumers look to shore up personal balance sheets will affect growth rate for a long time to come. A potential problem with this plan, many have pointed out, is that while the plan lifts bad assets off banks' balance sheets, it doesn't provide any new capital injection that banks can then lend, so the risk is that tight credit conditions continue to prevail.

Regardless of the longer range potential for this plan effectiveness, the short term reaction is the most important here, as credit markets are at a virtual standstill. If this plan is unable to loosen up the exchange of credit, then we will have to move to the next phase of the crisis, which could involve many more institutions failing. The meltdown scenario is still alive and well, unfortunately.

In other news, European banks are beginning to show signs of strain as well. The first victim has been Fortis bank, the largest Belgian bank. Already rumored to be in deep trouble late last week, the bank was partially taken over the weekend by the governments of Belgium, Holland and Luxembourg. Other and even larger European banks may also be in deep trouble if we are to believe the developments in the CDS market. European banks aren't under the same mark-to-market rules as their US counterparts (new mark-to-market rules were ironically passed just last year in the US) but may be in just as much trouble. Continued bad news in the European banking sector could weigh on the EUR.

Risk appetite is taking a hit to open the week with the latest round of news from the financial sector, which includes the stories mentioned above, the B&B partial nationalization in the UK, and news that Wachovia is on the ropes and may have a shotgun wedding with Wells Fargo. This could weigh on the carry trades again, though we will need to see what the reaction in the US trading session to the passage of the bailout package.

Interesting data coming out of Australia tonight, though we're not sure how much the market is really focusing on data just yet

Chart: EURJPY

The EUR could find itself under increasing pressure as long as credit markets remain frozen as there may be a pipeline of bad news in the banking sector ready to burst soon. In any case, EURJPY and other carry trades are likely to follow the general moves in risk appetite, and our outlook is one of 'when' this pair resumes its downward slide, rather than 'if'.

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