Further Weakness in Yen Crosses Will Depend on the Nikkei (page 1 of 2)

DailyFX Fundamentals 08-20-07

By Kathy Lien, Chief Strategist of DailyFX.com

Carry trades and stocks rally: Has the Fed saved the market?

Stocks rebounded today taking carry trades higher in the process as central banks around the world continued to inject liquidity into the financial markets. Although the bounce in equities and currencies stirs some optimism, the movements in the currency and stock markets can often times be distorting as well.

The bond and interest rate markets tend to be the most accurate reflection of the market's optimism and pessimism. Therefore today's sharp drop in one month and three month Treasury bill yields suggest that the Federal Reserve's discount rate cut on Friday has not completely stabilised the markets, especially since one month yields hit a three year low.

Last week, economists were comparing the moves to October 1998, but today they are comparing the moves to the stock market crash of 1987. This goes to show how severe recent movements have become.

Investors are flocking to the safety of short term US government debt as liquidity continues to dry up in money market funds and commercial paper. The fear of further credit problems has made principal protection everyone's top focus especially for money market funds that need to find a new place to invest after liquidity dried up in the commercial paper market.

Therefore even though we could see a continual recovery in the Dow, further gains may be limited to another 150 points. Federal Reserve Chairman Ben Bernanke, US Treasury Secretary Henry Paulson and Senate Banking Committee Chairman Christopher Dodd will be holding a closed door meeting tomorrow to discuss the recent volatility in the financial markets and its implications for the broader US economy.

Bernanke will probably come under pressure to do more to stabilise the economy and the housing sector. Although there are a few other intermediate options like foreign currency swaps, altering collateral requirements and lending directly to banks, only a cut of the Fed Funds target rate will satisfy the markets.

Although there will be speculation of an inter-meeting rate cut, we think that this is unlikely. Instead, what is more likely would be a lifting of portfolio caps on Fannie and Freddie which would help to bring some bids back into the bond market.

Meanwhile the only piece of US economic data released today was leading indicators, which came out right in line with expectations.

Further weakness in yen crosses will depend on the Nikkei

After the sharp recovery on Friday, it was hardly surprising to see the Japanese yen crosses rally today. The rebound has been mild for the most part as many currency pairs fail to recapture Thursday's breakdown point.

The first test of whether these rallies will continue will be in Asia. It took some time Sunday night for the Nikkei to respond to the recovery in the Dow on Thursday and even then the Japanese stock market ended much lower than its intraday high.

This type of price action suggests that Japanese traders, like many US traders don't believe that the worst is behind us but they are relieved that central banks continue be actively trying to help normalise the markets. The Bank of Japan added one trillion yen to its short term money markets today. The continual liquidity injections by the Japanese clearly indicate that they will not be hiking interest rates later this week.

Furthermore the recent strength of the Japanese yen is also doing its part with regards to tightening the economy.