It is the end of the third quarter and demand for US dollars has been exceptionally strong. This is related to repatriation flows and profit taking following yesterday’s big moves. The stock market closed up 488 points, which is approximately 60 percent of Monday’s historic sell-off. On the bailout front, since Congress is on recess for the Jewish holidays, there have been no significant developments. As a result, to credit today’s rally on the hope for a new bailout plan may be a bit of a stretch since the Senators haven’t even sat down to discuss potential changes. Therefore we still believe that yesterday’s sell-off is the market’s true sentiment towards the US dollar and US stocks and so far, there aren’t any concrete reasons to believe otherwise.

How Higher LIBOR Rates Impact Average Americans

Despite today’s recovery, there is evidence that investors and banks are still nervous. The overnight LIBOR rate which is the rate at which banks lend to each other hit an all-time high of 6.88 percent intraday. The 3 month LIBOR rate is also above 4 percent, the highest level since January. For the average American, overnight lending rates or the 3 month LIBOR have little significance until they realize that many home equity loans, lines of credit, student loans, small business loans and credit card rates uses LIBOR as an index. Therefore the rise in borrowing costs will surely be felt on Main Street as lenders charge higher interest rates on loans. For the average American, this adds further strain to their ever-thinning pocketbooks. Lending between banks is frozen as counterparty risk remains the number one problem in the financial markets. Volatility continues to remain high and we do not see any reason for that to change either. Yesterday, the S&P500 fell by the largest amount in 20 years and today, the index came close to rising by the most in 6 years. This schizophrenic behavior of the markets is sure to turn many investors gun shy.

Will An Interest Rate Cut Help?

In order to restore confidence at this stage of the game, the Bush Administration needs to shock the markets. One way of doing so could be through a rate cut by the Federal Reserve. As one of the most powerful psychological tools in the government’s arsenal, Bernanke may want to save it until there is evidence that the new bailout plan has failed to stabilize the markets. Fed fund futures have already priced in a quarter point rate cut between now and the October 29 monetary policy meeting. However the futures contracts have been wrong in the past and should the new bailout package prove to be stronger than the one proposed on Monday, the futures contracts will price in a smaller chance of a rate cut. For the Federal Reserve, after pumping a huge amount of liquidity into the financial system, inflation has become a very big concern. Therefore Bernanke will not readily agree to cut interest rates unless he has no other choice. Furthermore, a measly 25bp rate cut from the Fed may not do the trick. Risk aversion is so severe that the only things that can stabilize the markets may be a 50bp one shot rate cut or a coordinated easing by central banks around the world, but Bernanke will have a tough time convincing his Eurozone counterpart, Trichet.

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