- Carry Trades Plunge as Volatility and Risk Aversion Rises<p>
- ECB: All Talk and No Action
Dollar Surges but Tuesday could be Ugly for US Stocks
On Friday, we argued that the dollar may rally
this week as traders reflect on whether it is realistic to expect the
Federal Reserve to deliver an intermeeting rate cut or 75bp easing at
the end of the month. As we predicted, the
dollar has started off the week strongly, but for reasons other than
the ones that we have proposed. Stock markets around the world have
plunged. In fact, that’s an understatement because the one day slides in many of the indexes are the worst since 9/11 of 2001. The UK’s FTSE index is down over 5 percent, the German DAX is down over 7 percent and Hong Kong’s Hang Seng Index fell more than 5 percent. Even though the US stock markets were closed for Martin Luther King’s day, Dow futures fell 546 points or 4.5 percent. If
the futures do not retrace materially before the market’s open on
Tuesday and the Dow closes the day down by the amount that the futures
suggest, the index would see its fourth largest point loss ever. Such big moves in the equity markets certainly make an intermeeting rate cut by the Federal Reserve more likely. If stocks do not begin to recover anytime soon, the Fed will be forced to take measures to restore confidence in the US financial markets. Although part of today’s volatility could be attributed to the fear of a US recession and the lack of liquidity, the move began in Asia
and was sparked by speculation that the Bank of China could be forced
to write-off a fourth of its $8 billion subprime exposure. The announcement by the Chinese Bank would indicate that the mortgage mess has spread from the US to Europe and now into Asia. The world may be able to deal with a slowdown in the US economy, but the combination of a material slowdown in both US and China would be too much for everyone to handle. The lack of economic data on the US calendar this week will allow the equity markets to drive currency movements. Should Tuesday come anywhere close to being a record breaking day in US stocks, we expect to see the biggest drawdown in carry trades since the inception of the Euro. This
will in turn lead to more dollar strength against everything except for
the Japanese Yen which will decouple from the rest of the dollar pairs
due to its carry trade status.
Carry Trades Plunge as Volatility and Risk Aversion Rises
Carry trades live and die by 3 things; volatility, risk appetite and the direction of monetary policy. Unfortunately, in the current market environment, all 3 of these factors are not favoring carry trades. Volatility across the financial markets has surged. The VIX which is a measure of US equity market volatility closed last week not far from its 4 year high. Today,
the VDAX-New Index which is a measure of European equity market
volatility surged 39 percent, the largest rise since 2001. Risk
appetite has plunged with equities selling off while central banks
around the world are shifting from monetary tightening to monetary
easing. Therefore it is not surprising that carry trades are coming close to reporting the biggest drawdown since the inception of the Euro. Even
though the Bank of Japan has a monetary policy announcement tomorrow,
it should be a non-event as traders focus on equities and whether they
recover or extend Monday’s sell-off.
See how many of our DailyFX Forum Users believe that carry trades are a good bargain and vote for yourself
ECB: All Talk and No Action
The
Euro dropped 200 points today on the back of broad dollar strength,
weaker economic data and increasingly dovish comments from ECB
officials. In contrast to the central bank’s fears of rising inflationary pressures, German producer prices dropped 0.1 percent last month. This
was not much of a surprise since wholesale prices dropped for the first
time since October 2006. ECB members are growing less hawkish which
reduces the risk of an interest rate hike from the ECB in the first
quarter. We believe that the massive drop in
European equities and the continual problems in the subprime and
financial sectors will force the central bank to remain on hold over
the next few months and possibility even for the remainder of the year.
ECB members are already growing less dovish. Last
week, Mersch switched his bias from hawkish to dovish and today,
Wellink warned that the Eurozone economy is likely to slow more than
the central bank initially expected. Once again, we expect the ECB to be all talk and no action.
Visit the Euro Currency Room for resources dedicated specifically to the Euro.
Bank of Canada Expected to Cut Interest Rates
Carry trade liquidation, weaker economic data and softer commodity prices drove the Australian, New Zealand
and Canadian dollars lower today. Wholesale sales growth slowed in the
month of November which suggests that retail sales numbers for Canada, which are due for release tomorrow could be soft as well. The Bank of Canada will also be making an interest rate decision. They are expected to lower rates by 25bp tomorrow to 4.00 percent, putting Canadian rates below US rates temporarily. The Canadian economy has really taken a turn for the worst with growth in all sectors of the economy slowing. In Australia, inflationary pressures appear to be easing with producer prices rising only 0.6 percent last month. Although
central bank Governor Stevens still believes that inflation will remain
uncomfortably high in the near term, the drop in producer prices allows
him to postpone any plans to raise interest rates. This
flexibility comes in handy in the current environment when a rate hike
would only exacerbate the losses in the Australian dollar and
Australian stocks.
Discuss whether you think the Bank of Canada should lower rates on Canadian dollar Forum.
British Pound Falls to 9 Month Low
The
British pound remains weak as mixed economic data gives the Bank of
England no reason to postpone lowering interest rates next month. Public
finances and money supply grew more than expected last month but
mortgage approvals continued to drop. The housing market remains one of
the most vulnerable aspects of the UK economy and if housing goes, so will consumer spending.
Visit the British Pound Currency Room for resources dedicated specifically to the Euro.
By Kathy Lien, Chief Strategist of DailyFX.com
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