Carry Trade Unwinding Continues, More Losses in Store (page 1 of 2)

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.