This week we’ve seen a rally in the greenback as the Federal Reserve stepped in to save Bear Stearns from collapse.  Is this the start of a recovery for the US dollar (which has been brutally sold off for quite for some time), or just a temporary reprieve?

Background

The credit risk problem is not a derivatives problem.  Vanilla derivatives are what we trade, and are fundamental to the economy.  However, the raw material, money, was cheap and there were huge fees to be made and so the major players went beyond the traditional derivatives to cook up some derivatives that are so complex that they can’t even be properly valued. Once credit risks increased, these exotic derivatives collapsed.

Despite the fact that Bear Stearns took on risks that they didn’t understand (the common factor in the collapse of most similar firms), acted like the lords of Wall Street when they were making money and now have been bailed out with public money, the Fed’s actions are understandable. Bear Stearns is a major derivatives counterparty. The collapse of a key player can send huge shockwaves through the financial system.

The effect on the dollar

There has been a 3 day dollar rally after the bailout, which is the longest since the beginning of February.   This isn’t because anything fundamental has changed about the US dollar.   That’s still a bad new story - credit risk, war in Iraq, an upcoming election.  The Euro, Swiss Franc, Aussie and other currencies are still all stronger.  I believe the bailout has brought a temporary reprieve but not a reversal in the dollar’s fortunes.

Traders need to be able to quickly change direction as required, and holding periods are measured in hours, not days, so there is no sense getting hammered by the rally just to be right in the long term, but I believe that we’ll soon see the dollar selling off again.

There is always the long term and the short term direction.  I tend to want to play when the short term direction is in line with the long term direction and I think we’ll be seeing that occur in the next week. So my recommendation is to be ready for the next reversal, and resumption of the sell-off.

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Tags: forex commentary, greenback rally

This entry was posted on Sunday, March 30th, 2008 at 12:56 pm and is filed under Market Commentary. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.