US Treasury Bailout Fails to Restore Confidence in Financial System

Equity markets around the world dropped the most since 1997 on speculation that the $700 billion plan engineered by the U.S. Treasury will fail to restore investor’s confidence in the global banking system. The lack of liquidity has also affected the currency market in the form of in adverse interest rate rolls. Indeed, banks’ unwillingness to lend to each other has led to a spike in overnight borrowing rates which in turn has led to tight or even negative interest rate rolls for many currency pairs at the interbank level.

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Clear money market difficulties have led the US Federal Reserve to increase liquidity provided to open markets, extending up to a staggering $225 billion in 84-day credit to ease end-of-quarter funding constraints. Such actions reflects the Fed’s belief that money market conditions continue strained despite its great efforts to relieve them, and it seems that central bankers are almost willing to take matters into their own hands if the US Treasury’s bailout does not come to fruition. This likewise comes on the heels of an announcement that the US Federal Reserve Bank of Richmond, Virginia will provide liquidity “as needed” to facilitate Citigroup’s acquisition of the bulk of Wachovia’s assets.

Fed officials are clearly concerned with credit market conditions, and indeed it seems that money market liquidity could dry up further before conditions improve. As such, it is difficult to tell whether we can expect the buy/sell interest rates on forex positions to improve in the week ahead. As long as major financial institutions remain unwilling to lend to each other, forex market conditions may make for expensive rollover interest rate payments through even the most liquid of forex pairs.

Perhaps unexpectedly, however, such a drop in overnight lending market liquidity has not translated into elevated forex bid/ask spreads. The chart below shows Bid/Ask spreads available in FXCM retail trading accounts through 2008. Since FXCM uses prices provided directly by the world’s major institutions’ currency dealing desks, this represents accurate picture of spreads available in interbank markets. FXCM markups are accounted for in the below spreads.

[B]What’s Next for the Forex Trader?[/B]

Increased financial market indecision makes it difficult to predict what may happen next, and sharp gains in volatility expectations reflect that uncertainty. After falling sharply through the past week of trade, implied volatilities on EURUSD 1-week forex options have once again jumped through recent developments—surging to all-time highs.

Such a jump likewise coincides with a similar return to risk aversion and a rally in the low-yielding Japanese Yen. If we see similar deterioration through near-term trading, we could easily see Japanese Yen continue to rally through the near term.

We will keep traders up to date with any shifts in financial market conditions on DailyFX.com, so be sure to check back to monitor the status of ongoing financial market volatility.

[B]Written by Antonio Sousa, Chief Strategist and David Rodríguez, Quantitative Analyst for DailyFX.com[/B]

[B]To contact the authors of this report, e-mail asousa@fxcm.com and drodriguez@dailyfx.com [/B]