Carry Trades In for More Losses (page 2 of 2)

We have often said that carry trades thrive in low volatility and not high volatility environments.

The Japanese yen was the best performing currency pair of the day and Asian traders have yet to get an opportunity to respond to the latest moves. Given the recent losses and the degree of leverage that the market has become accustomed to over the past few years, many speculators are vulnerable to margin calls.

The principle of gravity applies well here; that is things fall much faster than they rise. According to one of our previous Carry Trade Special Reports, the maximum drawdown in a basket carry trades over the past decade was 10.5 per cent. We have drawn only half that amount at this point which means that there could be more room for losses.

Japan has its Corporate Goods Price Index due for release tonight. The market is looking for stronger inflationary pressures and even though that supports continual carry trade weakness, it should matter little.

Euro collapses as ECB steps into the market

The European Central Bank injected an unprecedented amount of liquidity into the bond markets today after overnight lending rates jumped to six year highs.

Central Bank President Jean-Claude Trichet and company are certainly not enjoying their August holidays given the recent volatility in the financial markets. Even though we criticised the ECB for downplaying the credit problems last week, we do commend it for acting so quickly in response to changes in liquidity.

In an official statement, it is not ruling out the need for further liquidity if calm is not restored in the money markets. Unlike the Federal Reserve, the ECB is prohibited from bailing out banks or anyone for that matter. Therefore if the blow-ups escalate and yields fail to regulate themselves, the ECB could change its mind about raising rates in September.

If the Bank sticks to its plans of raising interest rates next month, the rate hike will probably be their last.

Better trade surplus fails to help the British pound

Despite an improvement in the trade balance, the British pound also fell victim to the liquidity squeeze.

Unlike the Fed and ECB, the Bank of England did not inject liquidity and took no attempts to calm the markets. The market's perception of the British pound can be best seen through the currency's performance against the euro.

Despite a persistently strong currency, the UK trade deficit narrowed in June to the tightest level since October 2005. Unless a UK bank announces fund freezes, we continue to expect the pound to outperform the euro.

Commodity currencies weaken across the board

The Australian, New Zealand and Canadian dollars weakened across the board despite mixed-to-stronger economic data.

The Bank of Canada informed the markets today that it too is prepared to inject liquidity into the Canadian markets if needed. Canada has employment numbers due for release tomorrow. The drop in the employment component of IVEY PMI suggests softer job growth.