Carry Trades Rebound as Dow Sees Biggest Percentage Rise in Four Years (page 1 of 2)

Currency, equities and bond markets all have the same hope for the FOMC tomorrow

Equities, bond yields and the US dollar are all higher today indicating that the markets are collectively hoping for some reassurance from the Federal Reserve tomorrow.

The turmoil in the mortgage market has everyone worried that the worst has yet to come, but if the Fed still feels that the economy will "continue to expand at a moderate pace over the coming quarters", and the upside risks to inflation is a bigger problem than the downside risk to growth, then the rest of us may be able to relax as well.

The Dow has recovered all of Friday's losses but the most unique aspect of today's move was the fact that bond yields rallied as well. Over the past few weeks, when bond yields refused to follow stocks higher, the rally in equities was short lived.

Of course, the Fed's words could change everything, but today's move suggests that the dollar, bond yields and equities could extend their rise going into the FOMC rate decision. Once again, the statement will be the main focus since the Fed is not expected to lower interest rates. Although the market is pricing in a 100 percent chance of a rate cut by the end of the year, they are expecting the cut in the fourth quarter.

Yet, cautionary comments from the Fed are very possible. At his semi-annual testimony on the economy and monetary policy, Fed Chairman Ben Bernanke warned that things will get worse before they get better. Although it has already gotten worse since then, the chances that the problems will become even more severe still exist.

Part of the Fed's job is to ensure stability in the banking sector and Bernanke does not want to make the mistake of downplaying what could later be a serious economic problem. Then again, as recently as this past Thursday, Fed Governor Randall Kroszer also said that we have not seen subprime have "an effect on the broader economy."

If the Fed was to do what the market has already decided for them, which is to lower rates by the end of the year, they will eventually need to adjust their tone from hawkish to neutral to dovish. Tomorrow would be a good chance for them to do so.

Carry trades rebound as Dow sees biggest percentage rise in four years

On a percentage basis, the move in the Dow today was the strongest since April 2003. The market cared little about news that American Home Financial has filed for bankruptcy since that seemed inevitable after the mortgage lender laid off 90 per cent of its workforce on Friday.

Although the drop in oil prices could be partially credited for the rebound in the Dow, the late afternoon surge seemed to be driven by nothing more than a relief rally. The Chicago Board Options Exchanges' market volatility index (VIX) index, which is a measure of the volatility in the equity market plunged significantly after hitting a new 52 week high.

If the Federal Reserve does not say anything entirely bearish, then we could see further gains in both the Dow and in carry trades which have been moving tick for tick with US equities.

With no major Japanese economic data until the end of the week, this has been the primary driver of today's recovery in the Yen crosses. The rebound in USD/JPY is particularly impressive since the currency broke below 118 and hit a fresh four month low in early Asian trading. At that time, the losses in carry matched the March sell-off.

British pound hit by Foot and Mouth disease outbreak

The British pound has been weak even before the US stock market and US dollar took off because of an outbreak of Foot and Mouth disease in the UK this weekend.