The volatility that we have seen in the currency, stock and bond markets this past week has not been for the faint of heart. The Dow Jones Industrial Average fell 500 points on Monday, but instead of continuing lower over the course of the week, it staged the biggest 2 day rally in 5 years. Three to four hundred point swings in the stock market have become the norm this week as surprises and disappointments from the US government keeps traders on their toes.

The current Administration has thrown everything but the kitchen sink at the markets and based upon the recovery that we have seen over the past 2 trading sessions, something has worked. The most powerful of which is probably the Securities and Exchange Commission’s temporary ban on short selling and the hope that Paulson and Bernanke will deliver a new groundbreaking rescue plan that will include a bail-out fund that sops up all of the troubled paper. This has forced a massive short squeeze that drove stocks up more than 750 points in 2 days. Although there could have also been some genuine buying, the rise in gold prices suggests that some investors are still nervous. With no details disclosed at his press conference on Friday, it will certainly be another long weekend for US Treasury Secretary Paulson.

Don’t Expect a V-Shaped Economic Recovery, Maybe a W or L

The main take away from the recent developments is that we will not see a V shaped economic recovery. According to the data released this past week, the housing market and the manufacturing sector are still in trouble. Durable goods, the final numbers for second quarter GDP, new and existing home sales are due for release in this coming week and we expect the data to confirm the weakness of the US economy. Layoffs will rise, consumer spending will slow and corporate profitability will decline for at least the next 3 to 6 months. A recovery usually comes in one of four forms – U, V, W or L. We believe that in the current case of the US economy, we will probably see a recovery that looks more like a W or an L.

Investment Banks: 3 Down, 2 to Go

Of the top 5 investments banks on Wall Street, 3 have disappeared this year – Merrill Lynch, Lehman Brothers and Bear Stearns. The last ones standing are Morgan Stanley and Goldman Sachs (Citigroup and JPMorgan are considered universal banks since they have commercial banking divisions). With Morgan in merger talks, there could end up only being one independent player left in the market. For banks to consolidate is not a surprise but their consolidation now is more of an act of desperation than anything else.

However the pain is probably not over with more write-downs expected over the next few months. Barrons estimates that there will be another $150B of write-downs before we are done. This will stress the markets as well as central bankers and put a full fledged recovery in both the economy and financial markets at risk.

How Does This Impact the US Dollar?

The US government’s destruction of its balance sheet is ultimately negative for the US dollar especially as the budget deficit continues to grow but on a shorter term basis, we are seeing a very non-uniform performance in the US dollar. On Friday for example, the greenback strengthened against the Japanese Yen but weakened significantly against many of the other major currencies. We continue to believe that the outlook for the US dollar has changed because commodities are rebounding and the greenback has lost its safe haven status and therefore we have probably seen a top in the US dollar. Unless the European Central Bank agrees to global easing, we should see the EUR/USD revert to a period of range trading, although that range will probably be an extremely wide one characterized by sharp intraday swings. Expect more surprises and volatility in the new week if Paulson unveils his new plan.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.