British Pound Rallies in Anticipation of 6 Percent Interest Rates from Bank of England (page 1 of 2)

DailyFX Fundamentals 08-08-07

By Kathy Lien, Chief Strategist of DailyFX.com

Blame dollar weakness on the Fed, Bush and China

Volatility continues to rule the financial markets with the Dow rallying, retracing and then rallying once again. The yen crosses followed suit but the pullbacks were less severe.

This type of volatility in the markets represents significant two way action and a great deal of uncertainty on behalf of traders and investors.

The biggest news in the financial markets today was China's threat to dump US Treasuries and US dollars. Both the US dollar and bond prices have sold off drastically on the news even though we expect this to be nothing more than empty threats since China and the US are interdependent.

Treasury Secretary Henry Paulson made a special appearance on CNBC to refute fears that China has the power to rattle the US markets. President George Bush did the same on Fox News, indicating either how serious the government is taking the potential threat or the concern about the stability of the financial markets.

This caused the reversal of stock market gains, but stocks regained their momentum after Bush reassured the markets that the US economy can deal with market volatility and therefore they did not feel that Fannie Mae needed to be bailed out at this point.

The dollar is stronger today against the Japanese yen, but weaker against every other major currency. In fact, the dollar is slipping back towards its record lows against the euro. Part of the reason for the dollar's weakness today was due to China's announcement, but the other contributing factor is the commitment by other central banks to continue raising interest rates.

This morning, hawkish comments by Bank of England Governor Mervyn King pretty much guaranteed six per cent rates by the end of the year. The Reserve Bank of Australia raised interest rates last night and left the possibility of another hike by Christmas. Last week the European Central Bank (ECB) held a special press conference just to tell the world that despite the recent fluctuation in the markets, they still plan on raising rates next month.

In contrast, in the US, it is not just a matter of if, but a matter of when the Federal Reserve will announce its plans to cut interest rates. The clear divergence between what the Fed and every other central bank is doing is a big reason why the dollar not only weakened today, but could continue to weaken in the days to come.

Meanwhile there was good news on the data front. Wholesale inventories, wholesale sales and mortgage applications all increased more than expected. The big rise in wholesale sales suggests that we could see an upward revision to second quarter GDP.

Are carry trades back?

Carry trades continued to track the US stock market tick for tick. Today, impressive rallies were seen in all of the yen crosses, raising the question of whether carry trading is back.

Although it may be tempting to say that it is because we could see a bit more strength in pairs like AUD/JPY, USD/JPY and GBP/JPY, the market environment has changed significantly over the past few weeks. The age of easy money is over with many leveraged buyout deals and plans for stock buybacks cancelled.

These were the primary drivers of equity market strength in the first half of the year and their disappearance will make it much more difficult for the Dow to return to its record highs.