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US Dollar Rallies on Carry Trade Unwind, Interest Rates May Slow Advance

Tuesday, 14 August 2007 18:21:31 GMT  |  David Rodriguez, Currency Analyst

The US dollar gained for the second consecutive trading day, as increasingly risk-averse global markets sought the safety of the world’s foremost reserve currency. Morning economic data served to further boost the risk-linked greenback advance, with a surprisingly high producer price inflation result boosting interest rate expectations for the world’s largest economy.

The Euro fell further from recent heights, dropping 67 points to fresh monthly lows of $1.3540. The British Pound saw similarly pronounced declines, losing 150 points to breach the psychologically significant 2.000 mark—changing hands at $1.9971 through time of writing. Further carry trade liquidations made the Japanese Yen the only major currency to rally against the US$ on the day, with the greenback shedding a further ¥0.55 to ¥117.72. (For more on the carry trade unwind, see a DailyFX special report here)

Fresh economic data showed that producer prices rose significantly through the month of July, with the year-over-year Core inflation rate registering its highest since September, 2005. Indeed, the headline figure went far beyond consensus forecasts at 4.0 percent versus 3.4 percent expected—above the 3.3 percent pace seen in June. The strongest gains were unsurprisingly seen in the Energy measures, as total gasoline prices jumped 3.2 percent, while Residential Energy costs were similarly elevated at a 1.8 month-over-month rate. The net implications of the report were easily enough to send the dollar significantly higher in the trade that followed, as strong prices pressures will easily discourage the US Federal Reserve from lowering interest rates through the medium term.  

Despite the release, implied short-term interest rates on the December Eurodollar contract showed that traders fully price in at least 25 basis points in rate cuts through 2007. Dollar bulls will have to hope that such a trend reverses, as a Fed rate cut could easily derail the dollar’s attempt at a medium term rebound. As it stands, a recent double-bottom in the NYBOT-traded US Dollar Index suggests that speculators are reluctant to push the currency below August’s 30-year lows. Yet the outlook for future dollar performance will undoubtedly depend on the direction of market interest rate expectations.  

US equity markets proved far less fortunate than the domestic currency, with the three major indices down over 100 basis points through the day’s trade. The Dow Jones Industrial Average declines reached well into the triple-digits, leaving the DJIA 165 points lower to 13,071 at time of writing. S&P 500 shares fell the most on a percentage basis, losing another 1.36 percent to 1,433. All the while, the tech-heavy NASDAQ Composite shed 1.18 percent to 2,512.  

Fixed income markets continued to benefit from global risk aversion, leaving the benchmark 10-Year US Treasuries 7/32 higher to 100 and 5/32. Yields fell to their lowest in two weeks, losing 3 basis points to 4.73 percent.   

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