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Carry Trade Surges, US Dollar drops on Fed Announcement - Dollar to Fall Further?

Wednesday, 12 December 2007 20:24:31 GMT  |  David Rodriguez, Currency Analyst

The US dollar moved slightly lower through the New York currency trading session, as a sharp improvement in risk sentiment allowed forex traders to sell the dollar against higher-yielding counterparts. A joint decision by the US Federal Reserve and other major central banks to increase liquidity available to private institutions eased fears over the current credit market crisis—instantly boosting the Dow Jones Industrial Average and broader risky asset classes in its wake. Yet a sharp reversal briefly left the Dow in negative territory before a marginally positive stock market close. The US dollar saw similarly volatile price action, but a surge in the global carry trade managed to keep the greenback lower through the final minutes of New York price action.

The US Federal Reserve joined the European Central Bank, Bank of England, Swiss National Bank, and Bank of Canada in announcing innovative steps to ease current credit and money market duress—dominating financial market headlines on an otherwise quiet day of global event risk. Monetary policy officials released their nearly-identical plans to provide more flexible liquidity to financial institutions in a bid to ease current money market stress. Money markets unsurprisingly responded in kind—sending interbank lending rates substantively lower in the moments that followed. A near-instantaneous rally in US bond yields boosted the attractiveness of the domestic currency, but its initial gains were short-lived on a later surge in the forex carry trade.

The currency carry trade remained bid despite sharp Dow volatility, and high-yielding currencies have almost universally finished higher through the close. Indeed, the carry trade funding favorite Japanese Yen finished lower against all major currencies, while the similarly popular US dollar lost against all except the lower-yielding yen. Short-term momentum may continue to support the carry trade—especially as Asian stock markets have shown sharp rallies in pre-open futures trading. Otherwise, traders will watch for any surprises out of important short-term event risk to drive currency market volatility. 

Written by David Rodríguez, Currency Analyst for DailyFX.com

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