Complex Made Simple

Carry Trade Liquidation Hits the Currency Market

- US Dollar Falls as Traders Consider 50bp Rate Cut for January - Carry Trade Liquidation Hits the Currency Market - British Pound Dragged Lower by GBP/JPY and Oil

DailyFX Fundamentals 01-02-08

By Kathy Lien, Chief Strategist of

US Dollar Falls as Traders Consider 50bp Rate Cut for January

The first trading day of 2008 has not been good for the US dollar as the greenback weakened against every major currency with the exception of the British pound. Although the dollar had already started the US trading session on softer footing, the second wave of selling was triggered by the manufacturing ISM report which dipped into contractionary territory and fell to the lowest level in over four years. Not only did this number suggest that the manufacturing sector could be in a recession, but it also indicates that the dollar’s weakness is not helping exports. Instead, this disappointing data reinvigorated speculation that the US economy is already in a recession as argued by Pimco’s Bill Gross or could fall into one in the first quarter of 2008. Rate cut expectations have also shifted dramatically on the heels of the release. On Monday, the futures market was pricing in a 92 percent chance for a quarter point rate cut and an 8 percent chance that rates will be left unchanged at 4.25 percent. After today’s numbers, the futures market is now pricing in a 74 percent chance for a quarter point rate cut and a 26 chance of a half point cut. In other words, the situation in the manufacturing sector have become severe enough for traders to believe that the Federal Reserve will need to take more aggressive measures to stabilize the US economy. The minutes from the last FOMC meeting confirmed that growth is the Fed’s primary concern at the moment. The deterioration in incoming economic data has forced them to lower their growth estimates for 2007 and 2008. The sectors that face the biggest downside risks are housing and capital spending. On inflation, they were worried about the impact of higher import costs and a weaker dollar, but the Fed felt that labor costs were well controlled. Tomorrow, we turn our focus to the leading indicators for non-farm payrolls. Even though the current forecast is for weaker job growth, surprises in the Challenger layoffs report, jobless claims and the ADP employment report could shift expectations.

Carry Trade Liquidation Hits the Currency Market

Aside from the weakness of US economic data, carry trade liquidation is the biggest story in the currency market today. With no Japanese economic numbers due for release this week, the focus is on US equities. The Dow is down 237 points while USD/JPY has fallen close to 300 pips. On a percentage basis, this is the largest move since the subprime crisis hit its peak on August 16. January is supposed to be a strong month for stocks which means a strong month for carry trades. Even though it is only the first trading day of the year, risk aversion is the dominant trend in the market. Unless stocks recover quickly, this should be cause for worry because January is a time to lay on risk, not take it off.

British Pound Dragged Lower by GBP/JPY and Oil

The British pound was the only currency to fall against the US dollar today, leading many traders to wonder why there is such severe underperformance. The simple answer would be deteriorating UK fundamentals, but a closer look at the different relationships in the financial markets reveal otherwise. The biggest loser in the currency market today is GBP/JPY which has fallen over 600 pips. USD/JPY is also down 2 percent, which is the largest drop in the currency pair on a percentage basis since the subprime debacle hit its peak on August 16th. It is clear that GBP/JPY selling is a major reason why the British pound is unable to rally against the US dollar like the Euro, Australian and New Zealand dollars have. The relationship between the British pound and oil prices is also breaking down and when this happens, there tends to be sharp movements in the GBP/USD. UK manufacturing PMI was released today and to the surprise of no one, the sector accelerated at a slower pace. Construction sector PMI is due for release tomorrow and that is also expected to be weak.

Eurozone Continues to Benefit from Strong Manufacturing

Just comparing the trend of economic data, it is not hard to understand why the Euro strengthened against the US dollar today. As US manufacturing conditions contract and the ISM index falls to a 4 year low, manufacturing conditions in the Eurozone accelerate modestly. The Eurozone manufacturing PMI index for the month of December was revised up from 52.5 to 52.6 thanks to faster growth in France. Throughout 2007, everyone believed that the record high in the EUR/USD would hurt the manufacturing sector in the Eurozone and benefit the manufacturing in the US. Today we see that this prediction has been completely off base as the US manufacturing sector deteriorates while conditions in the Eurozone remain steady. Tomorrow, we are expecting German unemployment and Swiss manufacturing PMI. Both are expected to be softer.

Commodity Currencies Rise as Oil Prices Hit $100 and Gold Rallies $23

The Australian and New Zealand dollars are up strongly today thanks to a sharp rise in gold prices and broad dollar weakness. Investors are piling into gold as an inflation hedge and this is making $900 or $1000 an ounce a growing possibility. These moves are partially due to rise in energy prices. Oil hit $100 on an intraday basis as supply and demand concerns continue to grow. Unfortunately USD/CAD has not budged because the Canadian dollar has been pressured by CAD/JPY selling throughout the day. With the combination of weaker US economic data and stronger oil prices, we expect this to catch up to the loonie over the next 24 to 48 hours.