Unwinding of the “Armageddon trade” (short EUR/JPY) has helped boost EUR/USD and EUR/JPY. News that the Fed and Treasury are nursing Lehman through a sale takes any risk of a catastrophic collapse off the table. Despite the fact that a Bear Stearns-like failure was unlikely given Lehman’s access to the discount window, the market likes to latch onto a simple story and drive it to its logical extreme.
The other factor boosting EUR/USD were reports in the Chinese press saying China may cut its exposure to the US in the wake of the Freddie/Fannie takeovers. This near-death experience has supposedly alerted China to the need to diversify reserves. according to a Chinese investment bank. My guess is this is precisely wrong. Like PIMCO, China bought GSE debt based on the implicit backing of the US government. That backing is now explicit. Talk of diversification is like looking to close the barn door after the horse is gone. The fact that the currencies that China could diversify into have fallen like a stone for the last two months makes this argument a bit awkward at the moment as well. Watch what they do, not what they say.
The dollar may stay on the defensive if US retail sales disappoint later this morning as this will turn up the pressure on the Fed to trim rates again, postponing further tightening of US/EU interest rate differentials.