Lehman's Latest Developments Spell Trouble for Carry Trades and US Dollar

The US dollar dropped like a rock at the open of the Asian trading session on Sunday. It has been a long weekend for US government officials and the leaders of Wall Street Banks. Bank of America and Barclays pulled out talks to buy Lehman Brothers as the government refused to provide sufficient funding. The events of this past weekend is the same as last Sunday - only the names have changed with the GSEs swapped out for Lehman. It is very possible that Barclays and Bank of America wanted more government funding than JPMorgan received for Bear Stearns given their negotiating power and market risk. With capital being a problem for many banks, they do not want to stick their necks out without a big government guarantee. The only thing that is assured is volatility. Government bailouts can become a slippery slope and Paulson may not want to open the flood gates.

Dollar Collapses as Traders Prepare for Bankruptcy, Watch Out for Further Carry Trade Losses

The dollar collapsed against the Japanese Yen, Euro and British pound on Sunday evening as traders prepare for a possible Lehman bankruptcy. The ISDA (International Swaps and Derivatives Association) extended the hours of an emergency trading session between Wall Street dealers and Lehman Brothers so that they can net out or cancel transactions that offset each other with Lehman. No one knows what will happen with Lehman and what the credit quality of their assets are - all they know is that the right thing to do now is to reduce Lehman exposure. Counterparty risk is huge at this point for the currency market and that means carry trade weakness. At this point, safe haven bets is less of a driver of the US dollar than foreign investors dumping their US investments.

FOMC Statement Could be Dollar Bearish

The big event this week is the FOMC meeting. With the troubles in the financial sector, the last thing that the Federal Reserve wants to do is to talk about the possibly of raising interest rates. In fact, expect Lehman's troubles to drive up expectations for a rate cut over the next 12 months. Economic data has taken a turn for the worse and the troubles in financial sector are growing. The Fed will keep interest rates unchanged at 2.00 percent but the FOMC statement could actually be dovish. Consumer confidence improved for the month of September but we are particularly worried about the sharp drop in retail sales and the softer PPI numbers.

Expect a dollar negative week.

Kathy Lien
http://www.kathylien.com