Meltdown Continues, Lack of Fed Injection Fails to Calm the Markets; Only Beneficiary is the Dollar

Meltdown Continues, Lack of Fed Injection Fails to Calm the Markets; Only Beneficiary is the Dollar
The meltdown in the financial markets continued as stocks finished down over 200 points, bond yields continued to slide and the US dollar rose as traders flocked to the safety of the mighty buck.  Although the economic data released today was stronger than expected, it’s contribution to the dollar rally was limited since the move did not fully begin until lunchtime.  This is because the Federal Reserve does not have the flexibility to respond to the stronger trade and inflation reports.  Furthermore, these surprises were hardly surprising given the recent weakness of the US dollar, which has pushed up both exports and inflation.  The market’s priority at the moment is figuring out how soon the Federal Reserve could lower interest rates.  Strong data only seems to delay the inevitable.  Incidentally, over the past few days, the Fed has injected approximately $64 billion of liquidity into the banking system, the most since the September 11 attacks.  This has been seen as the preliminary step to monetary easing, especially if the blowups and losses in both the hedge fund and mortgage sector do not subside.  Interestingly enough, the Fed adstained from adding liquidity today, which is the first time in 3 months that they did not make any temporary repurchases of Treasuries from banks.  This comes after the Reserve Bank of Australia and Bank of Japan drained liquidity from their banking system which suggests that the markets may be returning back to normal, or at least that’s how central bankers feel.  Overnight lending rates have moved drastically over the past few days.  A look back at the movements of overnight Fed Funds rates shortly after 9/11, we see that interest rates normalized after 2 weeks. The only thing that is preventing the Fed from raising rates is inflation, which is why tomorrow’s consumer price data could be particularly market moving.  We continue to believe that the dollar will rise in the short term but decline  over the long term after the Federal Reserve finally buckles down and admits the need for lowering interest rates. 

Are Speculators Still Buying Carry Trades?
Nearly all of the Japanese yen crosses hit new 10 day lows on the back of continued carry trade liquidation. With no major Japanese economic data on the calendar, this breakdown is mostly due to today’s triple digit losses in the Dow.  However interestingly enough, retail investors continued to increase their long USD/JPY exposure according to the latest FXCM Speculative Sentiment Index.  Banks on the street are reporting the same increased exposure by FX margin accounts.  This indicates that despite the sharp breakdowns seen over the past few weeks, retail investors are not ready to give up on the trade that has made them money for the past few years.  From a price standpoint, this means that if the sell-offs continue, the moves lower could be fast and sharp as those who have gone long at current levels or higher get stopped out.  Meanwhile the VIX index of equity market volatility is up again, indicating that risk aversion remains highs. 

Australian, New Zealand and Canadian Dollars all See Sharp Losses
The New Zealand, Australian and Canadian dollars are the day’s biggest market movers.  All three of the commodity currencies are down sharply due to the combination of weaker economic data and continued flight to safety out of high yielding currencies back into the greenback.  The big surprise was in New Zealand, where retail sales dropped for the second month in a row.  Consumer spending is the backbone of any economy which makes the recent weakness extremely important.  There are reports that over $3 billion of New Zealand bonds are set to mature this month.  Most New Zealand bonds are owned by foreigners which suggest that the losses in the kiwi could exacerbate when the bond investors repatriate their funds.  Australian business confidence was also weaker than expected in the month of July.  Australian companies are also being hit by the subprime debacle with Rams Home Loans Group warning that profits would be weaker.  Meanwhile over in Canada, the combination of a weaker trade balance and news that Coventree, the largest non-bank issuer of commercial paper in Canada was forced to seek emergency funding when it failed to refinance debt that matured yesterday. 

Euro Drops to One Month Low, ECB Continues to Add Liquidity
The European Central Bank appears to be the only one still injecting liquidity into the banking system and that too may becoming to an end after ECB President Trichet said that conditions are returning back to normal.  The ECB has done a fantastic job of acting swiftly and aggressively to the money market crisis.  If liquidity injections do come to an end, everyone will be asking whether rate cuts are next.  Eurozone economic data released this morning was all weaker than expected with German GDP, French GDP, Eurozone GDP, and French consumer prices all falling short of expectations.  We continue to believe that the ECB will raise interest rates in September but that rate hike will be the central bank’s last.  For all Euro traders, it will be important to continue to keep an eye on Trichet for any signs of reluctance towards a September rate hike. 

Will the Bank of England Still Raise Interest Rates Now that Rates are Below target?
Like the Euro, the British pound dropped to a one month low against the US dollar today on the combination of broad dollar strength as well as weaker economic data.  Consumer prices dropped by 0.6 percent in the month of July, pushing the British pound back below 2.0 for the first time in seven weeks.  Given the weakness in producer prices for the same month, the market was already looking for a decrease in consumer prices, but not one by this magnitude. However it seems that the drop in food prices pushed the annualized pace of inflation growth below the Bank of England’s 2 percent target for the first time since March 2006.  The Bank of England did not have this information at its last meeting which means that it would not have had an impact on their hawkish inflation bias.  However the BoE has long been a very dynamic central bank and we believe that the drop in inflation will make the most recent interest rate hike the last. 

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