Carry Trade Unwinding Continues, More Losses in Store

DailyFX Fundamentals 07-27-07

By Kathy Lien, Chief Strategist of DailyFX.com

Why the dollar strengthens as the stock market falls

Reports of more subprime related losses have sent the markets tumbling once again. The stock market is down another 100 points, putting this week's losses in the Dow close to 500 points.

Carry trades and other high yielding currencies have followed suit as more victims of the subprime fallout surface. Domestically, Sowood Capital Management, a hedge fund founded by a former Harvard Management executive suffered bond losses in excess of 10 per cent.

A Citigroup analyst also released estimates of the potential losses at Fannie Mae and Freddie Mac, whose bond holdings are estimated to have dropped by $4.7bn. Internationally, Australian hedge fund Absolute Capital group suspended withdrawals from two of its funds as a direct result of subprime contagion.

The problems have now gone global which means that the age of easy money is over. Investors and lenders in general will be far more careful about who and what they are willing to fund. Even if the markets do rebound, sentiment has shifted so dramatically that we probably won't see the Dow hit 14,000 or fresh highs in carry trades again this year.

The most common question that we are being asked right now is why is the dollar rallying? The answer is because now that the global liquidation has deepened, investors are steered back into the US dollar because of its safe haven status. Many US investors have exposure abroad and when they cut their risky trades, they are also repatriating their funds back into US dollars.

Only a recovery in risk appetite will save the markets at this point. Although the Dow could bounce given the strength of its recent moves and the fact that prices are nearing key levels of previous support, keep an eye on bond yields because if they continue to remain weak or sell-off, more losses in carry trades and equities is possible.

Meanwhile, today's data gives traders no reason to be optimistic. Even though GDP rose by a more than expected 3.4 per cent in the second quarter, the drop in prices as well as slower personal consumption growth still give reason for concern.

Looking ahead, next week is busier than ever. Not only do we have non-farm payrolls on Friday, but service and manufacturing sector ISM is due for release along with personal income and personal spending. Even if we get stronger outcomes, the market may still look for the Federal Reserve to cut interest rates at the end of the year.

Carry trade unwinding continues, more losses in store

High yielding carry trades continued to perform horribly today with AUD/JPY and NZD/JPY falling another 300 points. The Chicago Board of Trade's Volatility Index continued to rise and is less than a point shy of its 52 week high.

Carry trades only perform well in low volatility environments. The fact that volatility shot up so much so rapidly makes carry trades, or the desire for yield, far less attractive for the risk. Even though USD/JPY and CAD/JPY are stronger, they have hardly put a dent into Thursday's losses.

Japanese data released overnight was mixed with consumer prices falling, but retail spending increasing on an annualised basis. The Nikkei was also down 418 points or 2.3 per cent overnight. This seems to matter little for yen traders because they are solely focused on the market's aversion for risk.

If stocks continue to collapse, carry trades will continue to fall. Meanwhile in the week ahead, there is a lot of data on the Japanese calendar including industrial production, the trade balance, household spending, labour cash earnings, and the jobless rate. The market has gone from pricing in a 64 per cent chance of an August rate hike to a 45 per cent chance.

Uptrend in commodity currencies comes to an end

The trend of multi-year highs in the commodity currencies has finally come to an end this week with the New Zealand, Australian and Canadian dollars suffering significant losses.

The biggest losers in the currency market today were also the NZD and AUD. As warned by central bank Governor Alan Bollard earlier this week, exporters are definitely beginning to feel the pain of a strong currency. Both imports and exports dropped significantly, turning the New Zealand trade surplus into a deficit.

Meanwhile there have been reports that model and momentum funds are aggressively selling the Aussie which means that they are no longer holding out the hope for a recovery in the high yielders and are instead either getting stopped out or initiating fresh short positions. Australia has retail sales next week which will be worth watching.

Canada on the other hand has raw material and industrial product prices along with GDP and IVEY PMI. USD/CAD has bottomed out and we expect the bottom to hold.

EUR/CHF sees biggest weekly drop in four months, EUR/USD weakens on dollar strength

Over the past two days, the Swiss franc has rallied significantly against the euro as a direct result of the currency's own safe haven status. The KoF report of leading indicators was stronger than expected, which has also helped, but the move in the currency pair began on Thursday.

In the week ahead, we have the UBS consumption indicator and PMI from Switzerland. Both are expected to remain strong, illustrating the overall health of the economy. The euro on the other hand has weakened for no other reason than dollar strength. There are a ton of PMI, unemployment and consumer spending reports due out next week, which could lead to some euro drive action.

Weak housing numbers weight on British pound

Like the euro, the British pound has sold off significantly today on the back of liquidation of high yielding assets as well as a broad dollar recovery.

House price growth continues to be soft which could be concerning going into next week's heavy economic calendar. We are expecting more housing market reports as well as money supply, consumer confidence, distributive trades, manufacturing and service sector PMI.

Overall the UK economy still remains healthy and the Bank of England could raise rates to six per cent by the end of the year. The global markets just need to stabilise before these factors come into play once again.