Unless you were on holiday in Mars, or working with BBC3, you’ll know all about the failed US bailout on Monday. Equity markets did sell off immediately, but the widely predicted Armageddon scenario of at least a 1000-point fall just didn’t happen. And Tuesday saw a determined rally across equity markets. So where’s all the fear gone and what are traders hoping for?

The First Bailout Plan
Yes, I know; reading about the bailout has passed my boredom threshold as well, but here’s a quick re-cap:

The Emergency Economic Stabilization Act 2008 had to be passed by the US House of Representatives on Monday 29th September before moving on to the Senate for approval on Wednesday. The trouble was that with US elections due on November 4th, these guys’ jobs were on the line. If ever there was a time to listen to the voters it’s just before an election, and the voters said NO! The Act fell at the first hurdle.

Reasons To Be Doubtful, 1,2,3
Even before the vote, investors voiced their doubts that this bailout would do the trick. Sure, it would give a short-term boost to confidence, but there were major flaws:

1) The feeling amongst the clever people was that $700 billion is nowhere near enough! Me? I struggle with how many noughts to add.

2) There was no agreement on the price to pay for all the rubbish loans and mortgages. This is pretty crucial because if the Fed pays top Dollar then the taxpayers are overpaying and the bankers are laughing. But if the Fed pays current market rates then the banks won’t receive enough to bump-start their lending as they’ll still be short of capital.

3) The plan did nothing to address the second round effects of the current crisis; the real problems for real people, like job losses, rising food and energy prices and falling house prices.

The New Bailout-EU Style
Hey, as sure as the Pope’s a Catholic there was always going to be another plan. The US has taken a leaf out of the EU model for dealing with ‘No’ votes,
“ Ve Vill keep asking you ze question until you give us ze right answer.”

Tuesday’s Jewish holiday allowed a further day for discussions, arm-twisting, bribery and, if needed, martial law in order to get a solution. The result, a new bailout act that the Senate will vote on tonight at 8pm. A favourable vote would put strong pressure on the House of Representatives to fall into line with a ‘Yes’ vote tomorrow.

The niggling problem I have is that as recently as Monday the popular opinion was that the proposed bailout would help to some extent, but that it had more shortcomings than Snow White. Any new bailout plan is bound to be a watered down version of the original and therefore is likely to be even less effective.

Rate Cuts
This Thursday the European Central Bank will meet for its monthly discussion on why they should put rates up. At the start of the week the market consensus was for a boring ‘No change in rates’, with the outside chance of a little teaser from Monsieur Trichet at the press conference.

But the buzz on the street on Tuesday was not only of a rate cut in Europe, but similar action in the US and UK. And the talk wasn’t of a token 0.25% off rates, more like 0.5% with ‘more if you want it, sir’. The Bank of England isn’t due to meet until next Thursday, October the 9th, but it doesn’t need much of a meeting if your boss phones you up and tells you to do it.

The problem here is, “It’s the liquidity, stupid.” At the margin, lower rates must help, but the big problem at the moment isn’t the rate that banks lend to each other, it’s the fact that they don’t trust the other banks enough to lend to them in the first place. For example US official interest rates are 2%, but on Tuesday it cost 6.8% to borrow Dollars overnight.

And looking at the real world, OK, it would be great for borrowers to pay less on their loans and mortgages each month, but consider this:

1) A lot of borrowers are already locked into fixed rates;

2) A lot of mortgages are priced off the LIBOR money rates, not the base rate. For example, In the UK, official rates are at 5%; 3-month money is 6.3%!

3) None of this will help Sally on the fish counter at Tescos, who still needs to borrow 25 times her salary to buy a one-bedroom garden shed. House prices need to fall further.

Oh, and the oil price might be falling, but check your friendly utility bill and you’ll see a bigger number than last year, that’s for sure.

Special Measures
These have been coming through thick and fast, but are really just designed to prevent more banks from going belly up. Central banks have been flooding the market with hundreds of billions (that’s far too many noughts) of Dollars and Euros. On a country-by-country basis here are some of the top efforts:

Ireland gained plaudits in general (but frowns from the EU bureaucrats) for its guarantee of Irish banks’ deposits and secured loans, allowing them access to the capital markets once again. But keep on eye out for comments from the credit rating agencies.

In the US it’s hard to keep track of all the new initiatives, but regulators are changing the way banks have to account for hard-to-price loans, allowing banks to mark them at a higher value. Also, the Federal Deposit Insurance Corp (FDIC) is looking at increasing the amount of individual deposits it insures.

The UK government laughed in the face of the Monopolies Commission and gave Lloyds TSB the bright green light to takeover HBOS (please). They followed this up with a far quicker nationalisation of Bodgit & Bingley than the Northern Rock debacle earlier in the year. The UK also looks likely to raise the level of deposit protection from £35,000 to £50,000, although there’s bound to be calls to match the full guarantee offered by the Irish government.

The Benelux countries tried to boost their hit rate (from zero) on Google by announcing bailouts, first of Fortis, then Dexia.

France announced that they’ll be introducing further measures before the end of the week, if they can be bothered to return from lunch. This morning there’s a rumour flying around that France will copy Ireland’s total guarantee of bank deposits. This will give an additional boost to confidence in their banks.

So Where Will All This Leave Us?
Over the next couple of days there’s a strong chance that the US bailout plan is approved and there’s the possibility of a cut in interest rates in the US, UK and Europe. Personally, I reckon that if the bailout goes ahead then the only likely rate cut will come from the UK. Markets being what they are, I’d expect an initial rally on any of the above events.

But once the excitement’s died down we’ll get back to looking at the economy, which is like an ocean liner; it takes a long time to turn around. Any reversal in falling house prices, rising unemployment and higher food and energy prices will take months, rather than days (The combination of slowing growth and rising prices is known as stagflation, and if you haven’t got a Scooby Doo what that means, check out Dr Who Meets The Stagflation Monster).

The other major concern remains the banking sector. The US taxpayers’ generosity doesn’t extend as far as the UK and European banks, whose balance sheets will limit their ability to lend, regardless of the level of interest rates. This lack of credit is already feeding down to smaller businesses that rely on bank credit to tide them over till their invoices get paid.

Finally, the safe assumption is that inflation is dying, along with the oil price. Fair enough, but what about further out. There’s a whole load of money being pumped into the system and, with the possible exception of the ECB, inflation is no longer the priority. Central bankers’ job descriptions have been hastily changed (in pencil) to concentrate on avoiding a depression, and in doing so taking their collective eyes off inflation.

How Am I Looking To Trade This?
For the time being I’ll continue to short the equity indexes. Tuesday saw equities regain a large portion of Monday’s losses, which I reckon had a bit to do with quarter-end positioning. There’s quite a bit of quality research doing the rounds, suggesting that we’re nearing the time for a serious rally. Whether I agree with the idea or not these guys have more money than me so I won’t want to take them on. But it doesn’t feel like we’ve had that final capitulation trade yet, so if markets rally on some combination of a bailout and/ or interest rate cut, I’ll be looking to short FTSE.

Taking into account the threat of further financial troubles, but with the potential for more inflation further down the road, how about gold as a good each way bet?

The forex markets are a bit trickier to call; there’ve been record 1-day moves in the Dollar-in both directions in the past few days. This is a pretty good hint that a lot of other traders are as clueless as me. I’ve been of the view that a $700+ bailout isn’t good for the Dollar in the longer term; that’s a chunky old deficit to be carrying around and will need a lot of generous donations from abroad.

But in the short term it seems that if the bailout is approved, the Dollar will benefit from the supposed boost to confidence in a US recovery. And if it fails then the Dollar strengthens on panicky repatriation of assets from abroad.

One thing’s for certain, there’ll be a lot of itchy trigger fingers over Thursday lunchtime with the ECB meeting and press conference.