Carry Trades Take Another Beating (page 1 of 2)

DailyFX Fundamentals 10-17-07

By Kathy Lien, by Chief Strategist of DailyFX.com

US Dollar: Volatility Rocks the Markets as Expectations for an October Cut Rises

Sharp moves in US equities triggered widespread volatility across the financial markets. The US dollar has strengthened because it tends to benefit in environments of rising risk aversion where we see traders and investors move back to cash and into the safety of the US dollar. Market sentiment has also shifted over the course of a few trading days even though economic fundamentals have not. Fed fund futures have gone from pricing in a 32 percent chance of an interest rate cut at the end of the month to 45 percent, leaving many traders wondering what has changed. Consumer price growth this morning was tepid while housing starts and building permits were horrid. The housing market continues to struggle as starts and permits fall to the lowest level in 14 years. Although it can be argued that the CPI numbers gives the Federal Reserve more leeway to lower interest rates, traders cannot ignore the fact that oil prices is on its way to $90 a barrel. Refineries have shielded US consumers from the higher costs by taking a hit to margins; this type of trend is not expected to last. With gasoline prices well off their May highs, consumers will have to shoulder some of the burden eventually. At that time, higher inflation pressures will manifest themselves. With inflation risks skewed to the upside, the Fed will find it difficult to lower interest rates even though the latest Beige Book says that economic growth has slowed since August. Slower economic growth and faster inflation is the definition of stagflation, which was last seen in the 1970s. At the time, the Federal Reserve Chairman Volcker increased interest rates from 4.75 to 20 percent over the course 3 years to combat double digit inflation. Of course, we are far away from double digit inflation levels at the moment, but the risk of inflation rising should at least keep the Fed hawkish. Therefore we do not expect the Fed to ease.

Carry Trades Take Another Beating

Continued weakness in the Dow has led to continued weakness in the Japanese Yen crosses. Last night, the Nikkei tracked US equities lower driving carry trades to 10-day lows. These losses were recovered when the Dow opened up 60 points, but the sharp intraday reversal in US stocks triggered another wave of selling. Risk aversion is certainly part of the problem, but part of the move may also be due to the expectation that the G7 could institute tougher language towards the Japanese Yen and the Chinese Yuan. Recent comments from Eurozone and US officials seem to indicate that the Yen will become the scapegoat for dollar weakness and Euro strength. For the Europeans, getting the Yuan and Yen to strengthen would at least help to lower the value of EUR/JPY. In the meantime, it is important to remember that the weakness of the Japanese Yen will continue to bring benefits to Japan's economy. The tertiary activity index was stronger than expected in the month of August.

Oil Hits Record Highs and then Reverses: What Does that Mean for CAD?

Canadian dollar traders cannot stop thinking about the possibility of $100 oil which is why the CAD remains strong despite weaker economic and an intraday reversal in oil prices. Oil prices hit record levels following news that Turkey will be making an incursion into Iraq. Prices however reversed shortly afterwards when inventories were stronger than expected.