Rally in risk hits a rough patch as uncertainty continues. But credit spreads are easing and must ease more for a continued renewal of risk appetite.

As a confirming indicator of last week's bloodbath in equity markets- it was reported that US investors yanked some $65 billion out of US mutual funds last week - the largest weekly withdrawal ever. This kind of flow could continue for some time, and was likely a key aggravator of the move in emerging market currencies during the recent panic. After all, many EM indices saw falls of 20% or more with equally sharp falls in their currencies - that creates some ugly math for investment portfolios and could hamper risk willingness in EM markets for some time to come as the perceived risk of investing in these markets has required a tremendous adjustment in recent months.

Credit spreads narrowed further yesterday, with the 3-month US Libor vs. US T-bill spread narrowing another 11-12 bps yesterday to about 430 bps, though it is still slightly higher than it was last week at this time. US 2-yr. dollar swap spreads also came in sharply as the US bond market opened yesterday. These spreads need to continue to fall sharply for risk appetite to renew its rally.

Norges bank is expected to cut rates by 50 bps today to bring the rate to 5.25%. Both NOK and SEK have been very weak of late and their failure to rally with the recent rally in risk appetite was worth not. Could EURSEK continue toward 10.00 for the first time since 1995? NOK soon looks like a value proposition at these levels with EURNOK the highest since a brief spike took it to 8.89 in early 2004, but the continued weakness in energy markets may weigh on the currency for now, so we dare not try to call a top in this market.

We talked yesterday about the focus now shifting to the "real" economy after the storm that has brought the financial industry to its knees. It wasn't only the banks that were heavily overleveraged during the credit bubble, it was every layer of the economy, including the consumer, who saved too little and consumed too much when times were good and now will want to create a buffer of savings for an uncertain future. The fall-out from the constricting credit markets has been hitting the consumer for some time, but is likely accelerating: we focus today on the US Retail Sales number for September, which will likely be an ugly one (Bloomberg expectations are running at -0.2% month-on-month for the less Autos number - this looks very optimistic to us.) A weak number won't necessarily be USD bearish as the USD tends to move more on moves in risk appetite lately - though a dramatically weak or strong number could be an interesting short term test of this pattern.

The first rumblings of a call for a more coordinated future for global financial markets are beginning. UK PM Brown has talked up the idea of more coordinated actions and even a new Bretton Woods-style approach and Trichet was out last night calling for global coordination as well. It is important that these voices are joined by other voices around the world for better coordination going forward, as the worst scenario in the coming recession would be any move by a significant power to a more isolationist stance. Watch this as a theme in coming quarters.

The USD and JPY sell-offs were quick to sputter yesterday as equities fell sharply after their historic rally. This underlines the idea that we won't simply soar back to the upside in risk appetite and may be in for a bit of two-way trading until a clearer theme emerges and as volatility subsides. We believe that the style of outright panic we saw last week is unlikely to re-appear. But options volatility is still extremely high. If you have a medium term view, you can cover it by selling an option against it if you dare - the premium is extremely rich these days. Still, one should tread lightly in these markets - liquidity is absolutely atrocious as many players have stepped away from the table.

Chart: USDJPY
We seem to have a key battleground on the risk appetite front in FX in the 103.00/50 zone in USDJPY, as long as we remain below here, the chart looks bearish, but a move and hold above would begin to neutralize the bear trend. 100.00 is a clear psychological support below 101.15 nominal support.