After a 500 point loss, where next?

It’s 8AM on the morning after a 500 point loss on the Dow. It could have been a lot worse, honestly. So I’m happy to have gotten away with that. Nevertheless, trading in Asia was not exactly confidence building with the Nikkei 225 down 5%. Europe is down another couple of percent too. So where do we go from here? If I were a clairvoyant, I could tell you, but since I’m not, you’ll have to make due with my measured opinion. I think we are headed for more volatility, yes. And we are going to see some major bankruptcies outside of Lehman, yes. But, there are a lot of things that could support the markets going forward, chief among them a robust policy response.

Today, at 8:30 AM EDT, the inflation numbers for the United States come out. What do I expect to see? Some, but not a ton of inflation relief. (Even if the CPI Index is flat, inflation will rise to 5.8% on the year). However, with WTI Crude futures down below $93 and Brent below $90, that’s a shed load of inflation relief in the pipeline. If we don’t see good numbers today, we are going to see nice numbers in October. That’s hugely supportive to financial markets.

Then, later today, the Fed is meeting and deciding on interest rate policy. I expect them to be pretty dovish. If the inflation number is good, we will see a 25bp cut is my prediction. Even if the number is not good, they’ll potentially cut. The US needs a steep yield curve to rebuild earnings in the banking sector and low short-term rates are the only way to get there with long-term rates so low. The Fed is not particularly hawkish so I think they want to cut and just need the excuse to do so. Whether they should cut is a debate for another time.

Also supporting the markets are low long-term and mortgage interest rates. With the recent flight to quality (i.e. government bonds) and the Fed’s bailout of Frannie, you have a lot of stimulus implicitly added through lower long term rates. This should be supportive of credit markets, particularly the US housing market.

On the other side of all that, we have continued jitters in the financial services sector. Last night both Washington Mutual and AIG suffered debt ratings downgrades. WaMu bonds are now considered junk. And then there’s Lehman Brothers, now bankrupt, with a massive unwind staring us in the face. They could be unloading a lot of paper over the next few weeks and that will not be good for financial markets – equity, debt or derivative. My personal view is that assets in currencies like the Swiss Franc and Singapore Dollar are looking very good right now. So are gold and silver.

There you have it, we’re set up for an eventful day. Everything is certainly not doom and gloom. But, we are by no means out of the woods yet.

Originally published at Credit Writedowns and reproduced here with the author’s permission.