Safe Haven Bid Helps Dollar as Markets Wait for the Next Shoe to
Drop
The foreign exchange and currency markets are finally feeling
the fallout from yesterday’s sharp move in Treasury bill yields. We had
warned in Daily Fundamentals that the rally in carry trades and the Dow could be distorting and that the bond market tends to have
the most accurate reflection of investor sentiment. With the yields on Treasury
bonds falling once again, it is clear that the market is not entirely convinced
that the Federal Reserve has done enough. Money markets have recovered a
bit after Monday’s dramatic losses but investors are continually willing to
accept lower yield for the safety of principal protection. The market is also
disappointed by the fact that nothing significant came out of the closed door
meeting held by Federal Reserve Chairman Ben Bernanke, US Treasury Secretary
Paulson and Senate Banking Committee Chairman Christopher Dodd this
morning. Dodd held a press conference after the meeting where he simply
stated that Bernanke has pledged to “use all the tools” at his disposal to
stabilize the financial markets. We are sure that this was his intention
all along, the only question is, how soon he would bring out the ultimate tool
in his arsenal which is an interest rate cut. The market is currently pricing in
75bp of easing by the end of the year but there has even been speculation of an
intermeeting rate cut or 50bp of easing in September. Interestingly enough, on a
day that the Fed cut the minimum fee for its securities lending program to lower
the hurdle for borrowing, Richmond Federal Reserve President Lacker said that
“financial market volatility, in of itself, does not require a change in the
target federal funds rate.” Over the past year, he has consistently leaned
towards higher interest rates. We are sure that most market participants
are glad that he is not a voter of the FOMC this year. The financial
markets are now waiting for the next shoe to drop. Whether a move by the
Fed comes first or another hedge fund or mortgage lender blowup will determine
where the dollar is headed next. Meanwhile keep an eye on tomorrow’s
initial claims report. A big increase could raise speculation that job
growth in August will be very weak.
Demand for Carry Trades Remain Low at Current Levels
The
narrower trading ranges in the Japanese Yen crosses indicate that the volatility
in carry trades is beginning to taper off. Even though all of the yen
crosses are lower today, they have not fallen below Monday’s low. A drop
in volatility is confirmed by the fact that the VIX has fallen more than 30
percent since hitting a four year high last week. Lower volatility usually
helps carry trades, but in an environment where investors are scrambling for
cash, interest in carry remains limited. On the interbank level, we have
heard that FX margin traders (their fancy term for individual traders) are
beginning to snap up value (in carry trades) at current levels. According
to our FXCM Speculative Sentiment Index however, that is not the case.
Even though we have seen traders initiate new USD/JPY positions on Monday and
Tuesday, the bulk of the increase is actually in short USD/JPY exposure and not
long. Meanwhile, the chances for an interest rate hike by the Bank of
Japan later this week is still at zero. The Bank of Japan continued to
inject liquidity into the financial system last night which is a sign that they
remain committed to keeping monetary policy easy. The one piece of Japanese data
last night was the all industry activity index, which was weaker than expected
in the month of June.
British Pound Hit by Fear that the Next Big Blowup Could be in the
UK
The British pound under performed both the Euro and US dollar
today on concerns that the next big subprime blowup could be in the UK.
There has also been talk that a UK hedge fund or insurance company could be in
trouble. The Bank of England also confirmed that a UK bank (possibly
Barclays) used the standby facility at a penalty rate of 6.75 percent to cover a
shortfall in funding. This is the first time that the emerging lending
facility has been tapped since the beginning of the subprime crisis. As
the problems grow, so will expectations that the Bank of England will keep
interest rates unchanged for the remainder of the year.
German ZEW Survey Hits 8 Month Low Supporting Call for Unchanged
Rates in September
With the subprime debacle, it is hardly
surprising to see the German ZEW survey fall below expectations in the month of
August. The Eurozone economy as a whole, particularly Germany has been and
will continue to be vulnerable to financial sector losses, which is part of the
reason why analyst sentiment has deteriorated. This supports the call by some
economists for the ECB to leave interest rates unchanged next month. We
haven’t heard much from ECB President Trichet over the past few days and we are
sure that he is closely watching the markets for signs of stability. The
Euro has traded in a tight range over the past 48 hours. Since only
current account and industrial orders are due for release tomorrow, the Euro
could very well remain in a range. Meanwhile the Swiss trade balance was
also weaker than the prior month, but that has not had much of an impact on the
Swissie.
Canadian, Australian and New Zealand Dollars All Give Back
Gains
The Canadian, Australian and New Zealand dollars all gave back
their gains today on the combination of weaker economic data and softer demand
for high yielding currencies. Even though Canadian consumer prices were
right in line with expectations, Canadian retail sales saw the sharpest decline
since September 2006. This was primarily due to a sharp fall in auto sales
and gasoline receipts. In comparison, sales excluding autos fell 0.3
percent, which was right in line with expectations. Most economists expect
the Bank of Canada to leave interest rates unchanged next month but some are
still expecting a rate hike in October. As for New Zealand, the annualized
pace of growth in credit card spending also slowed last month. This
suggests that retail sales could continue to remain soft.
Written by Kathy Lien, Chief Currency Strategist of DailyFX.com
