Time for a Rally in Carry Trades (page 1 of 2)

DailyFX Fundamentals 12-13-07

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar Strengthens as PPI and Retail Sales Question the Validity of Recession Calls
Is a recession in the US economy in 2008 possible? Yes. Is it probable? No. Before the FOMC rate decision on Tuesday, a poll by WSJ.com put the chance of a recession at approximately 35 percent. Yesterday's coordinated announcement by central banks around the world did little to alter those expectations, but taking a look at today's US data, it is hard to believe that a recession is probable. The US consumer, who is the backbone of the economy, continues to spend voraciously. According to the retail sales report, consumer spending doubled expectations in the month of November thanks to exceptionally strong demand for clothing and electronics. We are also finally seeing the impact of energy prices on inflation as producer prices grow by the fastest pace in 34 years. These reports are the main reason why the Fed did not cut rates by more than 25bp on Tuesday. Their hands are tied when it comes to monetary policy which is why they have been forced to come up with more creative ways to prevent the credit squeeze from worsening such as creating a Term Auction Facility. It can be argued that today's data is horribly backwards looking and the US economy is simply catching up with the rest of the world when it comes to inflation, but the strength of the US consumer cannot be overlooked. Analysts are notorious for being overly pessimistic as they have been about the Euro's impact on the Eurozone's economy. We had a record breaking Black Friday and Cyber Monday which should have been a good indication that retail sales in November would be strong. Consumer prices and industrial production are due for release tomorrow and we expect consumer prices to follow producer prices higher.

Time for a Rally in Carry Trades
The Japanese Yen crosses gave back some of yesterday's gains but that does not mean that the carry trade rebound is over. The Dow Jones Industrial Average staged a very impressive intraday rally having been down as much as 120 points around 2pm ET. So far, the financial markets have not had the reaction that central banks may have wanted from yesterday's big announcement which suggests that these central banks could have more tricks up their sleeve. The $40 billion in special loans is not a lot but the first coordinated by central banks from around the world since September 2001 indicates the severity of the credit squeeze in the eyes of global policy makers. They are testing the waters to see if banks will respond to the cheaper liquidity. If they do not, we could see more attempts at finding creative ways to inject liquidity into the financial system and boost investor confidence. For the currency market, this means a possible rebound in carry trades thanks to a continual rally in US equities. The Japanese Quarterly Tankan report is due for release tonight. In the past, this report has been very market moving, but in recent quarters it has lost its impact on the Yen because business sentiment has done little to give the central bank more or less reasons to raise interest rates. We expect the Tankan to be weaker because consumer sentiment continues to fall and borrowing costs continue to rise giving Japanese businesses little reason to be confident.

Why is the Euro Weaker?
Despite stronger than expected inflation in France last month, the Euro dropped to the lowest level against the US dollar this week.