US Dollar - Unwinding of Leveraged Bets Triggers Collapse in Financial Markets (page 1 of 2)

DailyFX Fundamentals 02-27-07

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar - The financial markets have taken a blood bath today with the Dow plunging over 400 points and the dollar hitting a 1 year low against the Japanese Yen. Risk appetite is plunging as investors bail out of nearly all assets. The moves have been very substantial and February 27, 2007 will either go down as a major historical turning point for the financial markets or an unparalleled buying opportunity. To read more about whether this is a major pivot point into a recession, read our Special Report on DailyFX.com. Having been the primarily funding vehicle for a lot of these leveraged bets, the Japanese Yen was a great leading indicator for today's move. The 9 percent drop in the Chinese stock market is being quoted as the initial trigger for the drop, but the broadness of the liquidation suggests that we have just seen a major shift in investor risk appetite. The moves today represent concerns about US growth. Durable goods orders dropped 7.8 percent in the month of January, which is the largest decline in 3 years. Excluding the volatile transportation component, orders fell by 3.1 percent. As we mentioned in yesterday's Daily Fundamentals, the market's reaction tends to be very volatile because of the underlying information provided by the ex transportation component. However by the end of the day, the headline number left a longer lasting reaction in the EUR/US - and this was exactly what we saw today. Even though consumer confidence hit a 5 year high and existing home sales increased by the largest amount in 2 years, the drop in durable goods orders was what mattered. As a component of GDP and a forward looking indicator for consumer consumption, the weak demand for big ticket items could trigger some concerns about the sustainability of the US recovery. The combination of low inflation, softer growth and problems in the sub-prime lending market will make it difficult for the Federal Reserve to raise interest rates again this year. Both the Financial Times and the Wall Street Journal have extensive coverage about the problems in the sub prime mortgage market today. According to the WSJ, banks are holding the lowest level of reserves to cover bad loans since 1990. With approximately $600 billion more adjustable rate mortgages to be reset to a higher market rate this year, two thirds of which are sub-prime, the risks for delinquencies and foreclosures are substantial. The market's risk aversion is so high right not that even if tomorrow's GDP, Chicago PMI or new home sales figures surprise to the upside, it may only have limited impact on the dollar.

Euro - The limited decline in the US dollar against the Euro confirms our belief that the major move in the markets today is primarily a liquidation of leveraged bets. Hawkish commentary by the central bank and stronger money supply figures continued to fuel gains in the currency pair. Remaining at a 17-year high, M3 rose by 9.8 percent year over year. The market was only looking for a mild rise of 9.5 percent. German CPI still accelerated in the month of February even though the rise was slightly softer than expected. This indicates that the Value Added Tax increase is finally revealing its impact on consumer prices, albeit a mild one. Separately, German retail manufacturing activity jumped slightly in the month of January, printing a 45 compared to last month's 43.9. The Eurozone figures rose to 49.8 from 47.9. Despite the improvement, the contribution to the Euro was limited because the index still remained in contractionary territory.