Carry Trades Rebound as Dow Sees Biggest Percentage Rise in Four Years

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.

The last time this epidemic hit the country was back in 2001 when the economic impact was close to GBP10bn. At that time, not only was the British meat shut out of the international markets, but tourism was also seriously affected. Between the spring and summer of 2001, the British pound fell from 1.4750 to 1.3680, which is over 1,000 pips.

Although the UK government is doing all that they can to contain the outbreak, the US, Japan and EU have already banned imports of live animals, fresh meat and milk from the UK. To some degree, this must have a negative impact on the UK economy and that inevitability is being reflected in the British pound today.

Even though the Bank of England will be delivering their Quarterly Inflation report on Wednesday, the FMD breakout could curtail any further pound strength.

Euro falls short of hitting its record high

The euro came within a hair shy of hitting its all time high of 1.3852. Much stronger than expected German factory orders and demand for EUR/JPY has helped the EUR/USD hold steady despite a strong rally in US stocks and US bond yields.

The market was looking for factory orders to retrace after rising strongly in May. However the strong euro seems to have only a limited impact on demand since orders increased 4.6 per cent which compares to the market's -0.6 per cent forecast.

This suggests that Tuesday's industrial production numbers could also be firm. European Central Bank (ECB) President Jean-Claude Trichet installed a strong bid tone in the currency last week when he held a surprise press conference to announce to that they essentially plan on raising rates next month.

In an environment where the US is on the verge of lowering rates, this has become very bullish for the euro at the expense of the US dollar.

Australian, Canadian and New Zealand dollars all up strongly

The Australian, New Zealand and Canadian dollars are all up strongly today despite the drop in both oil and gold prices.

New Zealand labour costs increased more than expected in the second quarter, which suggests that the labour market remains tight. Actual employment data will be released later this week.

Australian ANZ job advertisements fell by 0.5 per cent, but the market is still looking for a nice rebound in jobs last month. Before we get that data however, we have the Reserve Bank of Australia interest rate decision. The market is pricing in a quarter point rate hike tomorrow night.

When the central bank raises rates, they also release a statement. The high level of inflation suggests that the RBA could still raise rates again this year, but they will probably pause given global economic conditions.