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By Kathy Lien, Chief Strategist of DailyFX.com
US dollar: More problems equals more losses
The markets are selling off once again as the troubles in the sub-prime sector continue to grow.
Yesterday, everyone ignored news that American Home Mortgage (which commands 2.5 per cent of the mortgage market) had to delay its dividend, but today the double blow of major losses at Sowood Capital and C-BASS was too much for them to handle.
The Dow went from being up 135 points in the early US trading session to down 146 points at the market close. This was a swing of 281 points on an intraday basis. Unsurprisingly, bond yields and carry trades have also sold off while the Chicago Board Options Exchanges' market volatility index (VIX) index resumed its rise, indicating the return of risk aversion.
Economic data is also beginning to deteriorate. Aside from consumer confidence, every piece of US economic data released today was weaker than expected. On a growth front, personal income was unchanged in June while spending slowed. In terms of inflation, the market was looking for the monthly core PCE (Personal Consumption Expenditures) deflator to increase, but instead, it remained unchanged.
House prices and construction spending deteriorated as well but the big surprise today was the sharp decline in the Chicago PMI index and the jump in consumer confidence. Despite continued weakness in the US dollar, regionally, growth in the manufacturing sector is beginning to slow.
With both the Philadelphia Fed and Chicago PMI index dropping significantly, tomorrow's national manufacturing index (ISM) will likely follow suit. Do not be too discouraged however, as things may actually get better at the end of the week.
According to the "Jobs plentiful less hard to get" category in the consumer confidence report and the employment component of the Chicago PMI, non-farm payrolls due out Friday could actually be firm since both increased sharply. Whether or not this will overshadow any further losses in the subprime sector remains to be seen.
Contrary to what some people may think, the Fed is watching the stock market. President William Poole hinted today that the central bank is watching the markets closely and will act "in due time if and when evidence accumulates that action is appropriate".
That would involve deterioration in both inflation and employment, which makes keeping an eye on NFPs even more important.
Carry trades liquidation: How bad can it get?
Carry trades have sold off significantly over the past few weeks with GBP/JPY being the biggest loser. Having fallen from a high of 251.15 down to its current level of 241, it only took six trading days for the currency pair to erase the 1,000 pip rally that was three months in the making.
NZD/JPY, AUD/JPY and CAD/JPY all suffered the same fate, having each registered over 700 points in losses. As one of the most popular and successful trading strategies over the past few years, the strength of recent losses has caught everyone by surprise.
To the dismay of Mrs. Watanabe and anyone still long carry this is not the worse case of carry trade liquidation that we have seen. Between December 2005 and June 2006, our Dynamic Carry Trade basket had a drawdown of as much as 13 per cent.
From its peak last Monday, the portfolio is down seven per cent.
Kathy Lien, Chief Strategist, Daily FX
