U.S. Dollar Remains Very Volatile After Biggest Bank Failure in History and Bailout Setback

Since last weekend, market volatility has settled as traders were confident the worst of the financial crisis had passed. However, with the recent collapse of the world’s largest thrift (Washington Mutual) and ongoing debate over the specifics of Treasury Secretary Henry Paulson’s and Fed Reserve Chairman Ben Bernanke’s proposed banking bailout plan, it is clear that we are still navigating dire straights. While the capital markets and US dollar have held surprisingly steady through this most recent round of concern, the fundamental outlook is deteriorating relatively quickly. Today, the final reading on 2Q GDP was revised lower to 2.8 percent – doing little to curb growing speculation of a recession through the second half of year. This has further depressed rate expectations. Fed funds show certainty of at least a 25bp rate cut and a 30 percent probability of a 50bp cut.

Right now, the markets are more concerned with the immediate health of the financial markets – and rightfully they should be. However, when a solution has been found and speculators come back to the markets, there will be a bigger concern to consider for monetary policy officials and the outlook for returns: growth. Sentiment seems to be partially buoyed by the strong 3.3 percent annualized pace of growth through the second quarter. However, with unemployment at a five year high and rising, business investment looking anemic and other economies already contracting, a local recession is likely.

Considering WaMu had to be rescued by the FDIC, there is still considerable uncertainty surrounding the health of credit and financial markets. With the US government struggling to agree on the appropriate terms for a permanent bailout solution, traders are once again holding to short-term and other low-risk assets. Moving away from perceived risk, capital is finding its way into T-bills and other short-maturities products. On the other hand, there is even doubt as to what can be considered a safe harbor now after money market funds ‘broke the buck’ last week and with the US debt ceiling soaring. 

While the worst of the market’s volatility may have resolved itself last week, the fundamental conditions underlying the market continue to worsen as Capitol Hill debates. Without a definitive plan to remove the illiquid and toxic debt off major financial firms’ balance sheets (and one that would actually work to boot), the relief that was sparked last week was for not. Without a permanent resolution to prevent further collapses, ongoing write downs and fading liquidity will increase the strain on the system. This concern is starting to be more fully reflected in a number of markets and in market condition indicators. The benchmark stock indexes marked their worst two-day loss in six years this week, volatility in equities has held near 35 percent, commodities are beginning to rediscovery their safe haven status (as one of the few alternatives in a stricken market) and demand for short-term debt continues to grow.  

In any market there are two components to consider for investment: level of risk and the rate of return. The ongoing financial crisis is a reflection of risk, which is obviously leading investors to be much more cautious. The weight on risk appetite is partially reflected in the 10-year junk bond spread. Risk premiums in the index of 10-year, investment grade debt has soared to levels well beyond their levels during the Bear Stearns implosion. At the same time that risk has grown, the level of returns has shrunk with liquidity capping yields.  

Market condition indicators have offered a better reading on the health of the markets. While price action in underlying assets has been very dramatic this past week, fear indicators have maintained their heightened levels. Acting as a proxy for concern, volatility indexes have maintained their highs. The stock VIX gauge has held above the levels seen during the Bear Stearns rescue. For currencies, the DailyFX Volatility Index has also kept above 12 percent.