bio1

Carry Trades and Stocks Rally: Has the Fed Managed to Save the Market?

Monday, 20 August 2007 21:33:00 GMT  |  Kathy Lien, Chief Strategist

• Further Weakness in Yen Crosses Will Depend on the Nikkei
• British Pound Rallies on Stronger UK Economic Data

Carry Trades and Stocks Rally: Has the Fed Managed to Save the Market?
Stocks rebounded today taking carry trades higher in the process as central banks around the world continued to inject liquidity into the financial markets. Although the bounce in equities and currencies stirs some optimism, the movements in the currency and stock markets can often times be distorting as well.  The bond and interest rate markets tend to be the most accurate reflection of the market’s optimism and pessimism.  Therefore today’s sharp drop in one month and three month Treasury bill yields suggest that the Federal Reserve’s discount rate cut on Friday has not completely stabilized the markets, especially since one month yields hit a 3 year low.  Last week, economists were comparing the moves to October 1998, but today they are comparing the moves to the stock market crash of 1987.  This goes to show how severe recent movements have become. Investors are flocking to the safety of short term US government debt as liquidity continues to dry up in money market funds and commercial paper.  The fear of further credit problems has made principal protection everyone’s top focus especially for money market funds that need to find a new place to invest after liquidity dried up in the commercial paper market.  Therefore even though we could see a continual recovery in the Dow, further gains may be limited to another 150 points.  Federal Reserve Chairman Ben Bernanke, US Treasury Secretary Paulson and Senate Banking Committee Chairman Christopher Dodd will be holding a closed door meeting tomorrow to discuss the recent volatility in the financial markets and its implications for the broader US economy.  Bernanke will probably come under pressure to do more to stabilize the economy and the housing sector.  Although there are a few other intermediate options like foreign currency swaps, altering collateral requirements and lending directly to banks, only a cut of the Fed Funds target rate will satisfy the markets. Although there will be speculation of an inter-meeting rate cut, we think that this is unlikely.  Instead, what is more likely would be a lifting of portfolio caps on Fannie and Freddie which would help to bring some bids back into the bond market. Meanwhile the only piece of US economic data released today was leading indicators, which came out right in line with expectations. 

Further Weakness in Yen Crosses Will Depend on the Nikkei
After the sharp recovery on Friday, it was hardly surprising to see the Japanese Yen crosses rally today.  The rebound has been mild for the most part as many currency pairs fail to recapture Thursday’s breakdown point.  The first test of whether these rallies will continue will be in Asia.  It took some time Sunday night for the Nikkei to respond to the recovery in the Dow on Thursday and even then the Japanese stock market ended much lower than its intraday high.  This type of price action suggests that Japanese traders, like many US traders don’t believe that the worst is behind us but they are relieved that central banks continue be actively trying to help normalize the markets. The Bank of Japan added one trillion yen to its short term money markets today.  The continual liquidity injections by the Japanese clearly indicate that they will not be hiking interest rates later this week.  Furthermore the recent strength of the Japanese Yen is also doing its part with regards to tightening the economy.  In the meantime, the Yen crosses are driven less by interest rate expectations for Japan and more by the market’s overall risk appetite. 

British Pound Rallies on Stronger UK Economic Data
The British pound outperformed both the US dollar and the Euro today thanks to stronger economic data.  Rightmove house prices, money supply, BBA mortgage approvals and public finances all came out stronger than expected.  This suggests that domestic demand remains robust while the housing market remains stable.  This stability may be one the main reasons why the Bank of England has not felt pressured to add liquidity in the financial markets.  There has been a lot of talk that the Royal Bank of Scotland’s bid for ABN Amro could be in jeopardy after the recent credit problems.  The fear is that the consortium extending the bid may have problems raising cash from investors who may be licking their own wounds after this past week’s troubles.  If the bid is abandoned and no other buyer steps up to plate, this could be negative for the British pound in the near term for no reason other than sheer disappointment.

Canadian Dollar in Play on Tuesday
The Canadian dollar will be in play tomorrow with consumer prices, leading indicators and retail sales due for release.  The economic data is expected to be mixed with economists calling for an increase in consumer prices and leading indicators, but a decrease in retail sales.  The price action of the Canadian dollar today suggests that traders may actually be positioning for stronger numbers.  The Canadian government has been out in force trying to calm the financial markets.  Canadian Finance Minister Flaherty said today that the country is strong enough to get through the temporary impact of the global market’s re-pricing of risk; we hope this is true.  Meanwhile the Australian dollar is up strongly today while the New Zealand dollar trailed behind due to the drop in New Zealand visitor arrivals and producer prices. 

Euro Consolidates Ahead of German ZEW Survey
The Euro ended the day unchanged against the US dollar as the market tries to figure out whether the European Central Bank will continue to press forward with raising interest rates next month.  The guessing game will be helped by tomorrow’s German ZEW report, which tends to be one of the more market moving reports for the Euro.  Given the turmoil in the financial markets, we expect analyst sentiment to deteriorate significantly.  With no meaningful US data on the calendar, the German ZEW could be a bigger than usual market mover. Meanwhile over in Switzerland, producer and import prices were weaker than expected but this has had a limited impact on the Franc.

 

Written by Kathy Lien, Chief Currency Strategist of DailyFX.com

Resources

• free demo account
• forex courses
• open an account
• forex stream
• free webinars