The spectre of full nationalisation looms large over the likes of RBS and Lloyds, and the prospect of this is weighing heavily on the beleaguered pound. Sterling is being shunned as traders speculate on the scale of the governments eventual liability with regard to the banks.

The finger of blame for the current collapse in banking shares is pointing at the short sellers once again. John McFall, Chairman of the Treasury Committee, wrote to the head of the FSA asking them to investigate anecdotal evidence that some hedge funds have been shorting stocks.

It is almost inevitable that the short sellers get the blame; they are after all a convenient target. However, it should be recognised that conventional investors selling their holdings in droves can have a greater effect on a share price. After nationalisation of Railtrack and Northern Rock, investors could be forgiven for taking their cash and running at the faintest whiff of nationalisation for Barclays, RBS or Lloyds. While the short sellers may be playing a part, it is record losses, ongoing rumours and unquantifiable risks that rattle share prices the most.

Barry Ritholtz of www.ritholtz.com put it rather bluntly ” wipe out shareholders, bond holders, and all the bad debt and the junk paper these firms hold, zero it out,  and spin out the assets with clean balance sheets.” The Treasury has effectively admitted that it has no idea how much this will all cost UK tax payers eventually. This coupled with a rumoured downgrade to the sovereign credit rating of the UK government has pushed sterling down to below 1.3700 against the dollar level. The final nail in the coffin for Sterling came when the UK GDP figures came in well below estimates at -1.5% for the last quarter.

The coming weeks big ticket item is the next FOMC interest rate decision. With rates currently at 0.25%, there is little room for manoeuvre. Speculators will be following the announcement closely to see if the Federal Reserve will follow Japans lead from the 1980s, and cut rates to zero. Almost as important as the rate decision, will be any accompanying announcements on other measures the central bank is taking to get credit markets functioning again.

According to Bespoke Investments, the S&P 500 suffered its worst 9 day start to the year ever. The omens aren’t great with the rest of the year returning -0.74% when the market gets off to such a stuttering start.

US (un)employment and banking problems once again dominated the headlines. Citi group announced it will split in two after announcing an $8.29 billion loss. At the same time, Bank of America posted its first loss in 17 years while receiving a $138 billion bailout.

Economists talk about the prospects of a V, U or L shaped recovery for the worlds various economies, reflecting the expected speed of any return to growth. The prospect of the US or UK following a Japanese style “lost” decade or L shaped recovery would have been laughed at just a couple of years ago, but the world is a very different place today. Economists have made various predictions that the recovery will begin in the fourth quarter of 2009, or first quarter of 2010, but perhaps what is scaring people the most is the growing realisation that nobody knows what is going to happen. Arguably, the banks still haven’t confessed all their subprime sins and until they do, rumours will continue to spread concerning capital requirements. As they are at the epicentre of the crisis, this uncertainty could continue to shake markets for a good part of 2009. The global recovery may turn out to be worse than most people expect, it may turn out to be better, but nothing makes an investor reach for the sell button more than the unknown.

It was never going to be a good week for the FTSE when its two main sectors; finance and energy led the selling. Global banking giant HSBC hit the headlines after a Morgan Stanley note warned that it might have to raise $30 bn and cut its dividend in half. Deutsche Bank added to the misery by announcing a $6.33 bn loss in the last quarter. They were forced to deny rumours that this was down to a rogue trader. Considering the size of the loss, one has to wonder whether it is worse that such a loss was generated through authorised channels.

The biggest market mover at the start of the week was Bernanke’s speech, in which he outlined the need for further capital injections and guarantees for banks. Considering this came in the same week as BoA’s bailout, one can only assume that he was right on the money. The notion of UK banks requiring further capital injections was highlighted recently by The Bank of England deputy governor Charlie Bean. Most UK financials have now reversed all of last week’s gains, as traders speculate that this capital injection is moving closer to reality, along with the creation of a so called bad bank’ that would soak up toxic assets. Many analysts are now in agreement that something needs to be done, and although the treasury continues to deny such an act is on the cards, it may be a question of when, not if.

Adding to the gloom, major US blue chip companies, Intel and Time Warner both posted earnings that fell below analysts’ estimates. Wal-Mart also surprised by lowering its fourth quarter outlook. Analysts are concerned that if the world’s largest retailer had its figures set too high, then there is the real risk that earnings estimates are still too high across the board, going into earnings season. In short, the fear is that the bad news hasn’t yet been priced in, a scenario which is hardly going to be a positive catalyst for the next few months.

On the currency markets, it was a rare strong week for the pound. Sterling raced further away from parity against the Euro, and is pushing towards the $1.5000 level against the US dollar. Traders repositioned themselves after the bank of England cut by ‘just’ 50 base points, while at the same time speculation grew that the ECB will have to ease their relatively tight monetary policy soon. Traders now doubt that the Euro zone will be as strong as many thought this year. The British and American economies are still on the sick list, but now it is becoming apparent that struggling European nations such as Italy, Spain, Ireland and Greece could force the ECB to cut rates. The coming week is relatively quiet, starting off with Bernanke speaking on Tuesday. US retail sales come on Wednesday, with PPI and unemployment claims to follow on Thursday.

Stocks started 2009 on the right foot, with a broad based rally that took the Dow Jones within above the psychologically important 9000 level. The Dow hasn’t managed to successfully hold this level since the first few days of November. Commodities looked to be willing to make good some of the losses generated throughout 2008, with oil continuing to move above the $40 a barrel level.

The coming week is dominated by the UK interest rate decision, which comes on the back of Halifax’s announcement that house prices dropped 16.2% last year. This was the worst annual fall on record, bringing prices back to 2004 levels. The Bank of England also warned that the impact of the credit crunch was likely to intensify in the next few months. The MPC is expected to cut yet again to 1.5%, bringing UK rates closer to near zero US levels, and widening the gap between Sterling and the Euro. Friday also brings the all important US Non Farm Payroll figures which are expected to show another drop in the region of 500,000 jobs.

Jason Goepfert of the SentimenTrader.com, points out that the latest AAII (American Association of Individual Investors) Sentiment Survey puts US investors as having the lowest allocation of stocks in their portfolios since 1991. The level of cash hoarding has reached record levels. According to Goepfert, the only two times when cash allocations and stock allocations reached similar levels (around 40%) was 1991 and 2002. Both occasions were good contrarian indicators.

While it is unlikely to be a smooth ride, there are indications that markets are moving past the bad news to what lies beyond. A Bull trade predicting that the Dow Jones (Wall Street) will be above 9500 in 2 months time could return 103% over the next 60 days.

US pending home sales fell less than expected, and this provided good cheer to markets as it may indicate that the US housing decline is slowing. With so many mortgage backed securities still out there, a steadying of the US housing market could help alleviate some of the pressure on global financial institutions. The UK economy is still showing few signs of improvement though with October production figures falling more aggressively than expected. There was increasing chatter about a ‘Treasuries’ bubble last week. The yield
and 5 and 10 year notes plumbed to new depths, as traders continued their flight to quality. The yield on 3 month US Treasuries turned negative, meaning that investors were literally willing to pay to put their money somewhere that is perceived to be safe. Another unusual act to add to the ever growing pile of ‘once in a generation’ events, were reports that the Federal reserve is considering selling bonds under its own name.

The Pound held its ground against the Dollar, but was well and truly smashed by the Euro, which today set yet another record high against Sterling. The Euro even kissed the underside of its synthetic high of 0.9000 based on the old Deutsche Mark from 1996. Friday’s, news of HBOS’s dreadful £8bn write-down hit the general banking sector hard. Many economists predict that the UK economy won’t recovery until the back of 2009 at least, which means that lending conditions could get even worse for the UK banks.Until recently, the ‘independence’ premium hadn’t worked its way through in the banking sector. However, there are signs today that independence from the UK Treasury could start to become a significant advantage. On Friday, Lloyds, HBOS and RBS closed down 18%, 23% and 15% respectively. The remaining two major UK banks not to seek government assistance; Barclays and HSBC finished down just 8% and 2% respectively.

The banks have an almost impossible task of providing shareholder (and taxpayer) value, whist at the same time being seen to re-start lending to home owners and small businesses. Northern Rock shows precisely why these two competing aims are difficult to align. Northern Rock’s management team has been hell bent on repaying the government’s loan as quickly as possible, and it is making good progress in this regard. The problem is that to do this, it has reversed its lending policy, and is now lending out less than is being paid in. This is good news for taxpayers, but bad news for consumers.The economic landscape will be dominated by the US interest rate statement due on Tuesday. Analysts are expecting a fresh round of cuts from the Fed. Fed fund futures are currently implying a 60% probability of cut down to 0.25%, with a 30% probability of a cut down to 0.5%. On the same theme, UK rates are expected to push lower soon, and Wednesday’s MPC meeting minutes will help traders determinate the size of the likely cut. In my own view this is likely to be a further 1% as unemployment is forecast to approach 2m and then movce to 3m by the end of next year.