With the lack of any major US economic data on the calendar this week, the big event risk for the stock market and the US dollar is the Lehman Brothers’ Credit Default Swap settlement on October 21. The fear that European banks may be forced to pay out on the default protection has prevented the Euro and British pound from rallying despite the recovery in US stocks. The estimated payout on the CDS could be as high as $365 billion, more than half of the US government’s $700B bailout plan. The settlement should be most if not all in US dollars, which is why there has been a strong demand for dollars against the next 2 most actively traded currencies. If the CDS settlement triggers no bankruptcies, then the stability that we are beginning to see in the financial markets may last.

The sheer relief that there has been no negative news this weekend has helped the stock market and high yielding currencies recover. The liquidity that central banks have pumped into the financial markets are also finally having an effect on the credit markets. As indicated by the table below, everything from 3 month LIBOR spreads to the TED spread and currency volatilities have fallen since Friday and most of these indexes are down sharply from last Monday. This shift indicates that banks and other counterparties are becoming less risk averse and more willing to lend to each other which is helping equities and carry trades rally.

Is $700B Not Enough?

In Bernanke’s testimony on the budget before the House today, he talked about the need for another stimulus plan given the strong possibility of a deeper slowdown in the US economy. He said that the additional stimulus should be decided by elected officials and should come at a time when the economy is the weakest. The pros and cons of more government spending could be argued extensively and the White House has already indicated that they are open to the idea.

However for the currency market, Bernanke’s comments about a second stimulus plan reflects his continued concerns about the US economy. Going into next week’s interest rate decision, this suggests that the Fed will be looking to bring interest rates down to as low as 1 percent.

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