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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.
Kathy Lien, Chief Strategist, Daily FX
