Carry Trades In for More Losses

DailyFX Fundamentals 08-09-07

By Kathy Lien, Chief Strategist of DailyFX.com

Markets in turmoil: What next for the US dollar?

Today's turmoil in the financial markets has put traders, analysts, and even central bankers in shock. It seems as if no one expected the carnage that we saw today, because as recently as Tuesday, in its Federal Open Market Committee (FOMC) statement, the Federal Reserve downplayed the risk of a major credit or liquidity crisis opting instead to remain hawkish.

The Reserve Bank of Australia even went ahead and raised interest rates earlier this week while the European Central Bank (ECB) held a special press conference last week to tell the world it still plans to raise interest rates in September.

These same central bankers will need to reconsider their recent announcements, especially the Federal Reserve.

Fed fund futures are now pricing in a 100 per cent chance of a 25 base point rate cut next month followed by another rate cut before Christmas. To get a gauge of how drastic rate expectations have changed, just yesterday, the markets were pricing in only a 20 per cent probability of a September cut and 100 per cent chance of only one 25 base point reduction by the end of the year.

If traders are right and the Fed does cut interest rates next month, then they will have to make some sort of announcement expressing their shift in stance between now and then. Meanwhile the stock market is down 2.83 per cent, which is the largest percentage drop since April 2003. The evaporation of liquidity in the markets has hit both bonds and stocks, forcing the Federal Reserve and ECB to desperately try to calm the markets.

Both injected liquidity in reaction to the spike in Libor rates, with the ECB pumping in the largest amount of emergency funds since 9/11. The US dollar has rallied against every major currency with the exception of the Japanese yen, as traders and investors all move back to cash.

With the possibility of further losses, increasing liquidity is the most important thing for global investors. Therefore we expect the dollar to continue to benefit in the short term thanks to its safe haven status. In the longer term however, if the US is forced to cut interest rates, we could see the greenback underperform.

Unfortunately with the peak in adjustable rate mortgages not coming until October, the risk of defaults and late payments will only grow. BNP Paribas only announced that it froze its investment funds today, but in the weeks to come, it and other parties like it will have to begin announcing losses.

The only thing that can save the markets at this point would be surprise interest rate cuts from central banks around the world. That would be negative for the US dollar in the short term, but positive for the US economy and eventually the dollar over the long term.

Carry trades in for more losses

In yesterday's DailyFX Fundamentals, we posed the question 'Are Carry Trades Back' and our response was unfortunately no, because the age of easy money was over and volatility in the markets has returned.

Today, that is even more true, not because carry trades collapsed across the board, but because the Chicago Board Options Exchanges' market volatility index (VIX), which is the equity market's measure of risk hit a yearly high. 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.