Once again the currency markets were roiled by the continuing fallout from the sub-prime crisis after BNP Paribas announced that it is freezing redemptions in three asset-backed securities funds due to inability to fairly value their holdings. The high yielders, all of which were rallying up to that point, made a quick reversal and EUR/JPY, which has become the proxy for risk appetite in the FX market, tumbled nearly 200 points in the aftermath of the news.

As usual, the yen was the biggest beneficiary of risk aversion as speculators fled the carry trades on fears that the sub-prime problem may generate losses in the broader credit markets. Already, the EZ money markets have experienced a significant tightening of rates - enough to warrant a statement from the ECB that it stands ready to assure orderly conditions in the markets. Monetary authorities are clearly concerned that the recent practice by asset-backed hedge funds of arbitrarily suspending all redemptions may cause a crisis of confidence in all capital markets as investors decide to seek liquidity first and ask questions later.

For the time being, the situation appears contained and in some ways validates the argument that the risk in sub-prime securities was well dispersed amongst an array of market participants from US to Australia to Germany to France. However, the true danger to the markets could occur if the losses in sub-prime assets cause serious price volatility in other less risky fixed income assets, potentially creating debilitating losses in large money center banks and broker dealers. Such “seizure” of the financial markets would have wide ranging implications across all asset classes.

Ironically enough, this doomsday scenario would likely benefit the US dollar - the epicenter of the sub-prime mess - as the greenback would become bid on safe haven flows. Tonight’s price action is a good example of this dynamic at work, as the buck strengthened across the board following the BNP news. With no important economic reports to drive price action, the sub-prime story is likely to dominate trade for the rest of the day as currency traders turn their attention to the US equity markets. If the overnight news sends the Dow reeling, expect further gains in the yen, the Swiss franc and the dollar as speculators the world over suddenly lose their appetite for risk.

Boris Schlossberg is a Senior Currency Strategist at FXCM.