Australian Dollar Hits 18 Year Highs Before Succumbing to the Weight of Gold (page 1 of 2)

DailyFX Fundamentals 06-26-07

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: Is Risk Aversion behind the Latest Move?

Softer economic data weighed on the US dollar today but the shallowness of the decline is a testament to the market's overall demand for risk as well as its tolerance for US dollars.

The combination of another weaker housing market report, lower consumer confidence and warnings that the problems in the sub-prime sector could spill over to prime should have set off alarms for all carry traders and dollar bulls.

However, instead of dropping, the US dollar actually recovered over half of its losses against the Japanese Yen after the housing market numbers. In addition, the dollar held steady against the Euro and British pound, while gold prices hit a three month low.

If the market was truly becoming more risk averse because of the housing market issues, then gold prices would rise and not fall because investors tend to flock to the safety of gold whenever they are risk averse. Profit taking ahead of the Federal Reserve meeting has been blamed for the divergent market behavior as bond yields continued to rise.

This suggests that the market still expects the Federal Reserve to remain hawkish despite the problems in housing. The main reason the Federal Reserve will choose to do so is inflation. The national average of gasoline prices are back below $3 a gallon but the cost of milk, butter and corn are all up sharply.

This has forced companies like Domino's Pizza, Starbucks and Wendy's to either report a shortfall in profits or plans to increase prices. These changes will eventually hit core prices, which is one of the Federal Reserve's primary inflation gauges.

Therefore as long as we do not see a company like Washington Mutual take a big write-down in prime loans over the next two days, further dollar weakness ahead of the Fed rate decision should be limited.

More important than the problems in housing, which have been with us for some time is the outlook for consumer spending. Consumer confidence sank to a 10 month low in June. Weaker confidence is not likely to bode well for spending in the months to come.

Is it Carry Trade Liquidation or Profit Taking?

Carry trade liquidation has been blamed for the weakness in the Yen crosses today, but are the moves really carry trade liquidation or simply profit taking?

Sharp intraday reversals in USD/JPY, EUR/JPY, CHF/JPY and GBP/JPY suggest the latter. The stock market has been flipping between positive and negative territory over the past two days, which is indicative of strong two way pressure on equities.

So far, the move in the yen crosses fall far short of being labeled a liquidation, we need to see at least a one percent move in all of the currency pairs before becoming worried. Comments from Japanese officials suggest that they may be facing increased pressure from overseas authorities to stem the slide in the Yen.

Now that yen weakness has taken off against the US dollar as well, the Japanese may be feeling the pressure from Washington. Finance Minister Omi said overnight that they are "monitoring the FX markets closely" and that the market should be "aware of the risks of one-way bets".

Over the next few days, we have a tremendous amount of Japanese data due for release including retail sales, industrial production, consumer prices, and the jobless rate.