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Panic Eases But Conditions Far From Favorable
By John Kicklighter | Published  11/1/2008 | Currency , Futures , Options , Stocks | Unrated
Panic Eases But Conditions Far From Favorable

Panic, which has driven volatility and positioning through much of October, has eased its strangle hold on the market – for now. While liquidity fears have been quenched by unlimited access to dollar funds, sharp interest rate cuts and global bailout efforts, the markets have merely passed through one phase of a much broader financial crisis. A good indicator that conditions are not back to normal is an objective view of the where the market benchmarks and indicators that measure risk are at.

The options market shows a strong skew towards premiums for puts, suggesting traders are looking for protection and not willing to take on unnecessary risk anytime soon. Far more interesting though is the level of volatility. Despite the tangible drop in fear among investors, volatility in the currency market has climbed to a new high of 22.4 percent.

After a number of aggressive moves by central banks, policy officials and private entities, the markets have finally found some semblance of stability. However, just because risk appetite and asset prices are no longer in free fall doesn’t mean that conditions will improve from here. Most of the policy that was enacted over the past few months was aimed at reviving lender and investor confidence, and there are still blaring problems on both fronts.

Credit conditions are still very tight as default risk climbs to new record highs and rates on everything but the shortest termed money market funds, which are being artificially propped up by central bank activity, are still extraordinarily wide. Considering the long-term implications of this financial crisis, arguably the worst since the Great Depression, there is good reason for banks and investors to remain cautious. One prominent risk that can’t seem to be reconciled by a government guarantee is counterparty risk as banks, businesses and consumers are still painfully overleveraged through credit. This credit must be worked off, or an artificial build up would merely lead to an even more dramatic collapse later down the line. The next issue: recession. When the global economy is shrinking, lending, spending and investing naturally contract.

John Kicklighter a Currency Strategist at FXCM.