Life Won't be Easy for Carry Traders (page 1 of 2)

DailyFX Fundamentals 01-25-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: FOMC and Non-Farm Payrolls Call for a Busy Week

With an emergency 75bp rate cut from the Federal Reserve and Societe Generale losing $7 billion in a trading fraud, volatility has ripped through the financial markets this past week. For those traders who are hoping for the tides to calm in the coming week, they will have to continue hoping because the economic calendar is filled with market moving data. The Federal Reserve has their official monetary policy meeting on Wednesday while non-farm payrolls are due for release on Friday. According to Bloomberg, analysts are calling for only a 25bp rate cut but the futures market is pricing in a greater chance of a 50bp cut. Regardless of who is right, one thing is assured and that is volatility. In addition to the actual rate cut, the Fed's guidance will also have a meaningful impact on the currency market. An article in today's Wall Street Journal criticizes Bernanke for being too sensitive to stock market fluctuations. If that is the case, then today's 171 point slide in the Dow is not going to make him happy. Should equities give back more gains, the Fed may deliver a larger move on the fear that 75bp was not enough. We can't envision the FOMC statement being hawkish because we expect interest rates to fall to as low as 2.50 percent this year. Friday's non-farm payrolls report will confirm or deny whether the Federal Reserve has made the right decision. After the weakest rise in job growth since August 2003 analysts expect the labor markets to improve in the month of January. Although it may be difficult to believe that companies are still be hiring in the current market environment, jobless claims suggest that at least they are not firing. In addition to the FOMC and NFP, we are expecting durable goods, personal income, personal spending, Chicago PMI, the University of Michigan Consumer Confidence survey, manufacturing ISM and construction spending. The manufacturing sector is already in a recession and we expect it to remain that way, therefore the PMI and ISM numbers should not be dollar positive.

Life Won't be Easy for Carry Traders

We have stressed all week that even though carry trades are rallying, traders need to be careful because the current environment is not conducive for Japanese Yen crosses. Carry trades live and die by 3 things, volatility, risk appetite and the direction of monetary policy. Wednesday's 600 point intraday swing in the Dow and today's 171 point drop is volatility in action and if anything, traders have grown more risk averse with the Soc Gen incident. In addition, in times of US recession, one of the currency pairs that gets hit the hardest is EUR/JPY. We do not expect the rally in the Yen crosses to last, especially since these currency pairs were exceptionally weak on Friday. In the week ahead, there is a lot of Japanese economic data related to the labor market, consumer spending and manufacturing activity due for release. None of these are expected to be particularly market moving for the Yen given the barrage of US data, but in general, they should reflect the overall vulnerability of the Japanese economy.

ECB: Committed to Fighting Inflation

Throughout the recent turmoil in the financial markets, the European Central Bank has not wavered from their determination to prevent second round effects from threatening price stability. We have questioned their ability to act and believe that a rate hike before a rate cut is not a foregone conclusion.