Are Speculators Still Buying Carry Trades? (page 1 of 2)

DailyFX Fundamentals 08-14-07

By Kathy Lien, Chief Strategist of DailyFX.com

Meltdown continues, lack of Fed injection fails to calm the markets - but the dollar benefits

The meltdown in the financial markets continued as stocks finished down over 200 points, bond yields continued to slide and the US dollar rose as traders flocked to the safety of the mighty buck.

Although the economic data released today was stronger than expected, its contribution to the dollar rally was limited since the move did not fully begin until lunchtime. The lack of reaction stems from the Federal Reserve's inability to respond to the stronger trade and inflation reports.

This was hardly surprising given the recent weakness of the US dollar, which has pushed up both exports and inflation. The market's priority at the moment is figuring out how soon the Federal Reserve could lower interest rates. Strong data only seems to delay the inevitable.

Incidentally, over the past few days, the Fed has injected approximately $64bn of liquidity into the banking system, the most since the September 11 attacks. This has been seen as the preliminary step to monetary easing, especially if the blowups and losses in both the hedge fund and mortgage sector do not subside.

Interestingly enough, the Fed refrained from adding liquidity today, which is the first time in three months that they did not make any temporary repurchases of Treasuries from banks. This comes after the Reserve Bank of Australia and Bank of Japan drained liquidity from their banking system which suggests that the markets may be returning back to normal, or at least that's how central bankers feel.

Overnight lending rates have moved drastically over the past few days. A look back at the movements of overnight Fed Funds rates shortly after 9/11, we see that interest rates normalised after two weeks. The only thing that is preventing the Fed from raising rates is inflation, which is why tomorrow's consumer price data could be particularly market moving.

We continue to believe that the dollar will rise in the short term but decline over the long term after the Federal Reserve finally buckles down and admits the need for lowering interest rates.

Are speculators still buying carry trades?

Nearly all of the Japanese yen crosses hit new 10 day lows on the back of continued carry trade liquidation. With no major Japanese economic data on the calendar, this breakdown is mostly due to today's triple digit losses in the Dow.

However interestingly enough, retail investors continued to increase their long USD/JPY exposure according to the latest FXCM Speculative Sentiment Index. Banks on the street are reporting the same increased exposure by FX margin accounts.

This indicates that despite the sharp breakdowns seen over the past few weeks, retail investors are not ready to give up on the trade that has made them a lot money of over the past few years. From a price standpoint, this means that if the sell-offs continue, the moves lower could be fast and sharp as those who have gone long at current levels or higher get stopped out.

Meanwhile the Chicago Board Options Exchanges' market volatility index (VIX) of equity market volatility is up again, indicating that risk aversion remains highs.

Australian, New Zealand and Canadian dollars all see sharp losses

The New Zealand, Australian and Canadian dollars are the day's biggest market movers.