Dow Plummets 300 Points, Carry Trade Liquidation Continues (page 1 of 2)

DailyFX Fundamentals 07-26-07

By Kathy Lien, Chief Strategist of DailyFX.com

Dollar collapses, Fed Fund Futures show 90 per cent chance of rate cut by year end

The problems in the US housing market are worsening and anyone who is in long stocks, carry trades or the US dollar is feeling the pain. Next to the 3.2 per cent decline in the Dow back in February, this is the largest one day point loss since the beginning of the year.

Unlike the previous corrections that we had in June, there were plenty of clues that this one could be a lot worse. In yesterday's Daily Fundamentals we talked about how even though the stock market recovered, yields were lower, which suggests that there may be more bad news to come.

On Tuesday, we warned that risk aversion is returning, which meant that the sell-off in the yen crosses may be closer to liquidation than the profit taking that we have seen in the past. We were watching the Chicago Board Options Exchange Volatility Index or the VIX. At the time it was nearing February levels and today, it hit a new 13 month high.

High VIX readings represent a rise in risk aversion and typically coincides with a sharp sell-off in US stocks. We can also tell that risk aversion has returned because credit spreads have widened significantly.

The latest wave of panic selling has been caused by the combination of weak US economic data and news that Wells Fargo, the nation's second largest home lender and fifth largest bank will stop making sub prime loans through third party brokers.

We are clearly seeing the problems in the housing market extend beyond subprime. New home sales dropped 6.6 per cent in June while rising inventories drove the median price down 2.2 per cent. Durable goods sales also fell short of expectation as defense spending slowed. The labour market may even be affected with newspaper help-wanted ads dipping to a 49 year low last month.

The fact that jobless claims remains at healthy levels indicates that companies are not firing, but at the same time, it does not mean that they are hiring. In light of all of this weak data, Fed fund futures are now pricing in a 90 per cent chance of a rate cut by the end of the year; this represents a sharp jump from the 44 per cent chance reported yesterday.

Given all of the disappointments reported today, there is a decent chance that tomorrow's second quarter GDP growth figure will miss expectations. Even though the stock market has rebounded, yields are still sharply lower which suggests that dollar weakness may not be over.

Dow plummets 300 points, carry trade liquidation Continues

Rising risk aversion has caused a wave of carry trade liquidation. None of the yen crosses were spared in the second worst day for carry traders this year. The biggest losers were NZD/JPY and AUD/JPY, which dropped 400 and 340 points respectively.

Carry trades only work in a market that is willing to take on risk. With evidence that things could get worse before they get better in the US, it may be wise for carry traders to stand aside for the time being. Some economists are once again calling for a recession. Market expectations have shifted dramatically which makes it a far more unstable environment than a few months ago.

Tonight's Japanese data is not likely to matter at this point because the problems are far more severe than the risk of a rate hike by Japan.