Demand for Carry Trades Remain Low at Current Levels

DailyFX Fundamentals 08-21-07

By Kathy Lien, Chief Strategist of DailyFX.com

Safe haven bid helps dollar as markets wait for the next shoe to drop

The foreign exchange and currency markets are finally feeling the fallout from yesterday's sharp move in Treasury bill yields.

We had warned that the rally in carry trades and the Dow could be distorting and that the bond market tends to have the most accurate reflection of investor sentiment.

With the yields on Treasury bonds falling once again, it is clear that the market is not entirely convinced that the Federal Reserve has done enough. Money markets have recovered a bit after Monday's dramatic losses but investors are continually willing to accept lower yield for the safety of principal protection.

The market is also disappointed by the fact that nothing significant came out of the closed door meeting held by Federal Reserve Chairman Ben Bernanke, US Treasury Secretary Henry Paulson and Senate Banking Committee Chairman Christopher Dodd this morning.

Dodd held a press conference after the meeting where he simply stated that Bernanke has pledged to "use all the tools" at his disposal to stabilise the financial markets. We are sure that this was his intention all along, the only question is, how soon he would bring out the ultimate tool in his arsenal which is an interest rate cut.

The market is currently pricing in 75 base points of easing by the end of the year but there has even been speculation of an inter-meeting rate cut or 50 base points of easing in September.

Interestingly enough, on a day that the Fed cut the minimum fee for its securities lending programme to lower the hurdle for borrowing, Richmond Federal Reserve President Jeffrey Lacker said that "financial market volatility, in of itself, does not require a change in the target federal funds rate."

Over the past year, he has consistently leaned towards higher interest rates. We are sure that most market participants are glad that he is not a voter of the Federal Open Market Committee (FOMC) this year.

The financial markets are now waiting for the next shoe to drop. Whether a move by the Fed comes first or another hedge fund or mortgage lender blowup will determine where the dollar is headed next.

Meanwhile keep an eye on tomorrow's initial claims report. A big increase could raise speculation that job growth in August will be very weak.

Demand for carry trades remain low

The narrower trading ranges in the Japanese yen crosses indicate that the volatility in carry trades is beginning to taper off. Even though all of the yen crosses are lower today, they have not fallen below Monday's low.

A drop in volatility is confirmed by the fact that the Chicago Board Options Exchanges' market volatility index (VIX) has fallen more than 30 per cent since hitting a four year high last week. Lower volatility usually helps carry trades, but in an environment where investors are scrambling for cash, interest in carry remains limited.

On the interbank level, we have heard that FX margin traders (their fancy term for individual traders) are beginning to snap up value (in carry trades) at current levels. According to our FXCM Speculative Sentiment Index however, that is not the case. Even though we have seen traders initiate new USD/JPY positions on Monday and Tuesday, the bulk of the increase is actually in short USD/JPY exposure and not long.

Meanwhile, the chances for an interest rate hike by the Bank of Japan later this week is still at zero. The Bank of Japan continued to inject liquidity into the financial system last night which is a sign that they remain committed to keeping monetary policy easy. The one piece of Japanese data last night was the all industry activity index, which was weaker than expected in June.

British pound hit by fear that the next big blowup could be in the UK

The British pound under performed both the euro and US dollar today on concerns that the next big sub-prime blowup could be in the UK. There has also been talk that a UK hedge fund or insurance company could be in trouble.

The Bank of England also confirmed that a UK bank (possibly Barclays) used the standby facility at a penalty rate of 6.75 per cent to cover a shortfall in funding. This is the first time that the emerging lending facility has been tapped since the beginning of the sub-prime crisis.

As the problems grow, so will expectations that the Bank of England will keep interest rates unchanged for the remainder of the year.

German ZEW survey hits eight month low

With the sub-prime debacle, it is hardly surprising that the German ZEW survey fell below expectations in August. The Eurozone economy as a whole, particularly Germany, has been and will continue to be vulnerable to financial sector losses, which is part of the reason why analyst sentiment has deteriorated.

This supports the call by some economists for the European Central Bank (ECB) to leave interest rates unchanged next month. We haven't heard much from ECB President Jean-Claude Trichet over the past few days and we are sure that he is closely watching the markets for signs of stability.

The euro has traded in a tight range over the past 48 hours. Since only current account and industrial orders are due for release tomorrow, the euro could very well remain in a range.

Meanwhile the Swiss trade balance was also weaker than last month, but that has not had much of an impact on the Swiss franc.

Canadian, Australian and New Zealand dollars give back gains

The Canadian, Australian and New Zealand dollars all gave back their gains today on the combination of weaker economic data and softer demand for high yielding currencies.

Even though Canadian consumer prices were in line with expectations, Canadian retail sales saw the sharpest decline since September 2006. This was primarily due to a sharp fall in auto sales and gasoline receipts.

In comparison, sales excluding autos fell 0.3 per cent, which was in line with expectations.

Most economists expect the Bank of Canada to leave interest rates unchanged next month but some are still expecting a rate hike in October.

As for New Zealand, the annualised pace of growth in credit card spending also slowed last month. This suggests that retail sales could continue to remain soft.