More Reason to be Worried about the US Dollar (page 1 of 2)

DailyFX Fundamentals 01-08-08

By Kathy Lien, Chief Strategist of DailyFX.com

Carry Trades: Headed for More Losses?

The Dow plummeted 238 points today, triggering a major turn in carry trades. For carry trades to thrive, central banks need to be raising interest rates, volatility needs to be low, traders need to be optimistic and risk appetite needs to be strong. Unfortunately, this does not describe today's market environment. Over the past few months, many of the major central banks have lowered interest rates for the first time in years. The world is embarking on a major easing cycle which will contrast sharply with the global tightening cycle that lasted from 2004 to 2006. Volatility has also rebounded from its record lows while risk appetite has plunged. Part of the reason why carry trades continued to weaken is because traders expect global growth to slow even further. As the US flirts with recessionary conditions, the chance that the Federal Reserve will ease interest rates by 100bp is continuing to rise. At best for carry bulls, the Fed will ease by 50bp this year. At worst, they will ease by 125bp. Either way more easing is a necessity and this dynamic will make it difficult for carry trades to rally. The Dow broke a significant support level when it closed near its intraday low. It is realistic to expect at least another 100 point in losses which would take the index to its August lows. If the Dow to continues to sell-off, we will see further weakness in carry trades. Find out whether our DailyFX readers think that the Carry trade is a Buy or Sell and vote for yourself.

More Reason to be Worried about the US Dollar

After a brief recovery, dollar weakness continued as incoming economic data gave the market more reason to be cautious about the outlook for the US economy. Pending home sales fell 2.6 percent in the month of November which suggests that difficult times lie ahead for the housing market. With the exception of the South, contracts to buy previously owned homes dropped across the country. Tack on a sharp rise in consumer borrowing to pay for holiday purchases and there is good reason to believe that the US economy will continue to suffer. Retail sales are the key because steady consumer spending will give the Federal Reserve the flexibility to ease rates by only 25bp. If consumer spending buckles, the central bank will have no choice but to bow to market pressures and ease more aggressively by cutting interest rates 50bp. According to the comments by Fed Presidents Plosser and Rosengren, inflation remains a concern but the outlook for the US economy depends on housing. If the downturn escalates, expect widespread ripple effects.

Euro: No Major Moves until ECB Meeting

Despite volatility across the financial markets, the Euro ended the day virtually unchanged against the US dollar. Economic data was mixed with retail sales dropping 1.4 percent compared to a year ago, which is the sharpest decline in 11 years. This Euro bearish release was offset by German factory orders which increased strongly in the month of November. Foreign demand has remained steady but domestic demand was the primary catalyst for the jump in manufacturing orders. This is a reflection of the overall health of the German economy and part of the reason why the European Central bank will remain hawkish at their monetary policy meeting on Thursday. Before that, we are expecting the German trade balance, current account, retail sales and industrial production numbers tomorrow.