Carry Trade Liquidation Hits the US Dollar (page 1 of 2)

US Dollar - Traders banked their four day rolls at the close of business yesterday and began a massive liquidation out of carry trades that sent the US dollar sliding to its lowest level against the Euro in 14 months. Just as everyone has settled into the notion that it would be a quiet trading week, volatility spiked and currencies began to move. Given that many US and Japanese traders have left early for the holidays, which is quite common this time of the year, the lack of significant liquidity is sure to have played a major role in today's exaggerated price action. The dollar's biggest drop was against the Swiss Franc and the Japanese Yen, both of which are very popular carry trades.

Looking ahead, we want to warn that the combination of a depreciating dollar and a bleaker US economic outlook could resurrect talk of reserve diversification by central banks. This was the same case in 2004 when talk of reserve diversification was at its peak as the Euro surged from 1.22 to 1.3660 in a matter of 3.5 months. With the market so dollar bearish, any talk of reserve diversification could take the EUR/USD above 1.30. According to an interesting price study that we published as a special report today on DailyFX.com, over the past 20 years, the US dollar depreciated against the Euro 15 out of those 20 years during the month of December.

The seasonality is even more apparent if we zoom into the past 12 years, where there were only two instances that the US dollar managed to rally in the last month of year. Meanwhile only minor economic data was released today. Weekly mortgage applications dropped last week by 3.7 percent, erasing most of the prior week's gains. Jobless claims ticked higher, bringing the 4 week average to 317k, which signals that payrolls could be a bit softer in November. The final University of Michigan consumer confidence index was also revised down from 92.3 to 92.1 as consumers were slightly less optimistic about the current economy.

Euro and Swiss Franc - The Euro screamed higher today and came within an arm's length of the psychologically important 1.30 level. Economic data released this morning was mixed with French consumer spending falling short of expectations while Eurozone industrial orders dropped less than expected. France's economy has really been the laggard lately and we suspect that the latest bout of Euro strength will only do further damage to the fragile economy.

For an export dependent region, the higher the EUR/USD rallies, the bigger the damage that the currency could do to the local economies. If you recall, the major reversal that we saw in the EUR/USD in late 2004 was triggered by a round of disappointing economic data. Although we may still have some more room to go in the EUR/USD on the upside before seeing a meaningful reversal, the odds of deteriorating economic activity are very high at this point.

If the EUR/USD stays at its present level when the European Central Bank holds their monetary policy meeting, there is an extremely big possibility that ECB President Trichet will signal that the December rate hike is most likely their last. Even though the ECB is concerned about inflation, the strong currency also reduces inflationary pressures. The most important piece of economic data due for release tomorrow is the German IFO report on business sentiment.

The prospects of an interest rate hike and the strength in the currency should lead to a drop in business confidence after a large jump last month. Meanwhile the market has had a strong demand for Swiss Francs over the past few days thanks to firmer economic data.