Equity markets around the world dropped the most since 1987 on speculation the U.S. Treasury will fail to restore investor’s confidence in the global banking system. Gains in the Japanese yen and losses in the stock market accelerated after the U.S. House of Representatives rejected a $700 billion plan to rescue the financial system. The lack of liquidity has also affected the currency market in the form of 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.

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 EUR/USD 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.

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.

Antonio Sousa is a Currency Analyst for FXCM.