The US dollar continued its extensive rally on Monday, but it had little to do with fundamentals given the plunge in US non-farm payrolls for the ninth consecutive month on Friday. Instead, we’ve seen that the risk aversion pervading the market has led traders to sell assets like stocks for US dollars who then use them to buy US Treasuries in a classic bout of “flight-to-safety.” In fact, as of Friday 30-year Treasuries and EUR/USD held an 82 percent inverse correlation, highlighting the importance of demand for government debt. Meanwhile, the CBOE’s VIX Volatility Index hit a record high of 58.24 today, signaling the fears lingering in the markets. The Federal Reserve has been taking extraordinary measures to try to deal with all of these problems, and this morning they announced that they would start paying interest on depository institutions’ requires and excess reserve balances. With more money on deposit at the Fed, the central bank will have better funding for their liquidity injections. Furthermore, the New York Fed said, “Without authority to pay interest on reserves, from time to time the Desk has been unable to prevent the federal funds rate from falling to very low levels.” As a result, this measure should help to stabilize rates.

Looking ahead to Tuesday, the minutes from the Federal Open Market Committee’s September meeting will be released and this could draw attention once again to the problems plaguing the US economy. It was somewhat surprising to see the markets completely brush off the disappointing non-farm payrolls numbers, as the risks for recession remain very high. However, bearish commentary by the FOMC members may enough to remind traders just how bad things are. Fed fund futures are fully pricing in a 50bp cut on October 29, and if the minutes suggest that the Committee may actually consider cutting rates, the US dollar could pull back sharply. My fundamental bias for the US dollar on Tuesday: bearish. However, I don’t think this bull trend for the greenback should be ignored.

Euro, British Pound Plummet On European Financial Crisis Concerns, Intervention On the Way?

If you thought financial market conditions were bad in the US, take a look at Europe. The region’s financial institutions are facing the same difficulties in the credit markets there, but unlike with the Federal Reserve, the European Central Bank has stubbornly left rates steady at 4.25 percent since July and up until that point, the Governing Council had remain extremely hawkish. However, over the course of the weekend, a meeting amongst the leaders of Europe’s four largest economies - Britain, France, Germany and Italy - failed to yield any sort of solution or plan for their ailing financial sector, which triggered massive selloffs in European equity markets. In fact, France’s CAC 40 Index ended the day down over 9 percent while Germany’s DAX plunged more than 7 percent. The situation in Europe appears to be more complex than in the US, as European countries lack common budgets and regulations for banks and brokerages that deal in cross-border transactions. As a result, it is very difficult to come up with a large blanket program like the Treasury’s Troubled Asset Relief Program (TARP), which was signed into law by President George W. Bush on Friday.

Is a global bailout effort on the way? The US Treasury announced today that the finance chiefs of the G7 will meet on Friday ahead of the annual meetings of the International Monetary Fund and the World Bank. There was no agenda disclosed for the meeting, but with investor confidence souring more and more by the day, the G7 has little choice but to find some way to try to soothe fears in order to avoid an all-out collapse. A joint intervention effort to this degree may be unheard of, but these are also unprecedented global market conditions.

Japanese Yen the Strongest Currency of Them All?

The Japanese yen was easily the biggest gainer of the day, surging 3.32 percent against the US dollar, nearly 5 percent versus the Canadian dollar, British pound, and Swiss franc, and a whopping 9.80 percent against the Australian dollar. Risk aversion and subsequent carry trade selloffs were behind the move, which is why high-yielding currencies like the New Zealand dollar (-7.08 percent) and Australian dollar got hit so hard. With the credit crisis still hitting the world’s financial markets quite hard, true financial stability is not likely to come soon. This leaves traders highly unlikely to pile back into the carry trade. My long-term fundamental bias for the Japanese yen: bullish.

Commodity Dollars Hit Hard On Broad Deleveraging, Aussie Faces RBA Rate Decision

A broad drop in carry trades along with falling commodity prices weighed heavily on currencies like the Australian dollar, New Zealand dollar, and Canadian dollar. Meanwhile, the release of Canadian Ivey PMI failed to have a big impact on USD/CAD, despite the stronger-than-expected reading. In fact, Ivey PMI rose to 61.0 from 51.5, though the index had been anticipated to slip to 51.0. The increase suggests that business activity accelerated during the month of September, but the breakdown of the report isn't nearly as encouraging. The employment component actually fell below 50 - signaling contraction - which bodes ill for Friday's national labor numbers. Furthermore, the price component actually rose even though commodities have traded broadly lower in recent months. Overall, Canadian growth may appear to be faring well right now, but given the global slowdown, the export-dependent economy could feel the headwinds in late-2008 and 2009. Looking ahead to the next 24 hours, only the Australian dollar faces significant event risk as the Reserve Bank of Australia will announce their rate decision. According to a Bloomberg News poll of economists, the RBA is expected to cut rates by 50bps to 6.50 percent. This would mark the lowest rate in a year and the second rate cut in a row, as the RBA reduced the cash rate by 25bps on September 2. However, there are two factors to watch here: 1) if the RBA only cuts by 25bps and 2) the Board’s policy statement for some sort of forward-looking bias. Check out our Australian Dollar Forecast for more on the rate decision.

Terri Belkas is a Currency Strategist at FXCM.