Currency markets are responding to an ongoing backlash against nationalization of the banking system with investors edging back into the waters of riskier asset classes. The Australian and Canadian dollars are recovering from weakness yesterday as equity markets are becoming more and more convinced that Treasury Secretary Geithner, President Obama and Governor Bernanke are all speaking with the same voice telling shareholders that the banking system is first of all sound, but second they won't lose their stakes through government intervention.

02-26-2009 12:41 PM ESTCurrent PricePut Open IntWeekly Change in Put Open IntCall Open IntWeekly Change in Call Open IntPut/Call Open Int Ratio30-day Historical Vol (%)Implied Volatility (%)
Swiss Swiss1.165916,32250611,08141.5N/A16.2

No matter how much one agrees with the statement that banks are better off in the hands of private shareholders, it doesn't do anything to change the fundamental situation, which is getting worse and not better by the day. Look at the Asian currencies whose declines reflect ever-weaker export markets. /p>

If you can imagine sitting behind closed Washington doors one can imagine the brainstorming behind the problem of how to mend the broken economy. Sure the answer lies in the banking system, but the devil is in the detail. Shares of the Financial Select Sector SPDR ETF (XLF) closed at $9.67 on November 21, 2008 before falling a further 22% to $7.41 at the February low. Such investor fear needs to be laid to rest and the question being raised by politicians and bankers over that period is how to stop financial share prices falling. The answer is to show me that each company is viable and hence the mandate to commit the largest banks stress testing. If the largest banks fail the stress test, the government will commit more capital, but it won't convert them to public ownership.

Seeing this shroud of fear gradually being lifted around the globe, investors sense that there is a bargain to be had in financial companies. As news of this visit to the bargain basement leaks to other investors, there is a growing sense that they will be ultimately be rewarded by an unfreezing of the lending logjam, which will help raise aggregate demand, which will kick-start manufacturing plants and raise demand for commodities.

That line of reasoning is logical, but extremely premature. It's very important not to confuse dampened volatility across all asset classes as we scrape the bottom of the equity markets with any sign of recovery. While the VIX measuring aggregate option premium of S&P 500 index components registered 67% at the November low, it fell to 43% at the depths of last week's despair. Many commentators note that this recoil signals that the worst might be over. However, the price of implied options volatility on the XLF still rang up at 118% last week at the bottom having been 126% at the November low. That's an important distinction to make and one which currency investors should take note of as they discount recovery.

The euro is trading higher against the dollar at $1.2740 after dollar bulls were invigorated yesterday by falling equities in the United States. The yen continues to weaken ahead of Friday's likely twin delivery of doom and gloom in employment and inflation data, both widely anticipated to worsen. Rising unemployment and declining prices hardly need a stronger yen in the face of weaker external demand.

Currency implied options volatility is slowly giving way as investors see that lower equity prices didn't embroil individual currencies. Going forward, foreign exchange traders expect narrower ranges. But that's a dangerous prediction to make if economic data continues to roll over, which we expect.

Investors are buying the pound against the dollar this morning at $1.4332, admittedly off a weak performance yesterday. Bulls on the British currency hope that increased lending will spur demand. Guarantees on loans at RBS by the government has helped the bank bolster its capital but at the cost of increased government ownership from 70% to 84%. Some £325 billion of RBS investments have been lifted into a state insurance program, while at the same time the bank will shift its toxic assets into a new unit – a bad bank.

For now the backlash and rise in share prices is a positive development. Signs that banks are increasing their balance sheets through lending are steps in the right direction, but one has to wonder whether it will be enough. Opposing politicians note that the lending program won't be deep enough to have an effect and there is always a risk of a taxpayer backlash with consumers bearing the strain of the bank bailout. Chancellor of the Exchequer, Alistair Darling has his work cut out in convincing the populace that the nationalization measures will be bread today and jam tomorrow, which is what he's hoping for. The exit strategy is to protect, strengthen and sell bank shares back to private investors. But as Mr. Darling notes, his bank mending program may take time to feel the impact on the economy.

All said and done, it's imperative not to be sucked into the view that the economy is healing on its own, nor that no government assistance is necessary to drag the financial system through the war. Over coming weeks investors will be treated to rising unemployment and further signs of demand weakness. It's going to take more than confidence to repair the banks and it's likely that the current wave of optimism will have its legs swept away on the back of such negative data dragging commodity sensitive currencies beneath as it happens.