In a move that was more or less expected by most traders and investors across the world, the US government announced this past weekend its plans to take the reigns on Freddie Mac and Fannie Mae. However, what wasn’t expected was the reaction that would follow the bailout. There was a clear and notable sign of relief as risk appetite jumped for equities; but in other assets, the price action was surprisingly reserved or somewhat counterintuitive. In this report, we’ll go over some of the preliminary details of the bailout plan, review what kind of impact the news initially had on the major asset classes and forecast the ultimate fundamental and price influence this announcement will ultimately have the markets going forward.

The Plan

For the past few months, market commentators and policy officials had grown increasingly critical about the health of Freddie Mac and Fannie Mae – two government sponsored enterprises that hold or insurer nearly half of the mortgages in the US. With nearly $5 trillion in mortgages, the future of these two agencies held a considerable weight over the health of the US housing market and growth, and even the global credit markets. Theoretically, a collapse on that scale could easily have triggered the next leg of the credit crisis – one that would have been far worse than anything we have seen over the past 12 to 14 months. However, there was little to no chance that the government would let the lenders fail. So, the question became when – not if – the US Treasury would take over.

On Sunday, after heated speculation and many unconfirmed rumors, officials confirmed the Freddie Mac and Fannie Mae had been taken into a government conservatorship. In taking over, both firms CEOs have been ousted, the Federal Housing Agency has been put in charge and all dividends have been suspended. The more important details aren’t yet set in stone. Treasury Secretary Henry Paulson has hinted at a possibly putting up $200 billion to support both lenders; and he has opened up lines of short-term funding for both Fannie, Freddie and 12 other home loan banks.

The Currency Market

The History: To understand how this announcement would impact the currency market, we need to recall what has happened to the Forex market over the past year. After the subprime meltdown and the subsequent housing recession took hold, the outlook for the US economy and risk appetite crumbled. These are two distinct influences on the deeply liquid market. First, the US dollar plunged as the Fed was spurred to an aggressive pace of interest rate cuts and international investors feared the world’s largest economy was heading for a recession. The other unique concern surrounded the popular carry trade. Any strategy that flourishes in conditions where volatility is low and yield differentials are expected to grow does not do well when credit seizures are a constant threat and interest rates are slowed by growth trends.

The Future: After the US government confirmed its plans to take over Freddie and Fannie, the US dollar plunged and the carry trade rebounded from its lowest level in over two years. However, both this sharp moves were ultimately retraced. The EUR/USD and GBP/USD pulled back 375 points and 500 points from their respective intraday highs. The response from the US dollar shows the question of whether the bailout will boost confidence in the US and its housing market and securities or if it merely hints at a more dire situation for the economy than originally expected. In this respect, the strength or weakness of a currency is determined by its fundamental outlook with respect to the forecasts for all its counterparts. Right now, the economic outlook for the UK, Japan and Euro Zone are still more ominous. However, this action will act to remind traders that the economy may not be as strong as second quarter GDP numbers suggest. If US data continues to cross the wires in the red, it will have a greater impact in chipping away at the dollar’s advance.

David Rodriguez is a Currency Analyst at FXCM.