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Tuesday February 27, 2007 - 23:07:41 GMT
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US Dollar – Unwinding of Leveraged Bets Triggers Collapse in Financial Markets

DailyFX Fundamentals 02-27-07

By Kathy Lien, Chief Strategist of DailyFX.com

- US Dollar – Unwinding of Leveraged Bets Triggers Collapse in Financial Markets
- Hawkish Comments and Faster Money Supply Growth Contributes to Euro Rise
- Japanese Yen Earns the Title of Being the Day’s Best Performing Currency Pair

US Dollar - The financial markets have taken a blood bath today with the Dow plunging over 400 points and the dollar hitting a 1 year low against the Japanese Yen. Risk appetite is plunging as investors bail out of nearly all assets. The moves have been very substantial and February 27, 2007 will either go down as a major historical turning point for the financial markets or an unparalleled buying opportunity. To read more about whether this is a major pivot point into a recession, read our Special Report on DailyFX.com. Having been the primarily funding vehicle for a lot of these leveraged bets, the Japanese Yen was a great leading indicator for today’s move. The 9 percent drop in the Chinese stock market is being quoted as the initial trigger for the drop, but the broadness of the liquidation suggests that we have just seen a major shift in investor risk appetite. The moves today represent concerns about US growth. Durable goods orders dropped 7.8 percent in the month of January, which is the largest decline in 3 years. Excluding the volatile transportation component, orders fell by 3.1 percent. As we mentioned in yesterday’s Daily Fundamentals, the market’s reaction tends to be very volatile because of the underlying information provided by the ex transportation component. However by the end of the day, the headline number left a longer lasting reaction in the EUR/US – and this was exactly what we saw today. Even though consumer confidence hit a 5 year high and existing home sales increased by the largest amount in 2 years, the drop in durable goods orders was what mattered. As a component of GDP and a forward looking indicator for consumer consumption, the weak demand for big ticket items could trigger some concerns about the sustainability of the US recovery. The combination of low inflation, softer growth and problems in the sub-prime lending market will make it difficult for the Federal Reserve to raise interest rates again this year. Both the Financial Times and the Wall Street Journal have extensive coverage about the problems in the sub prime mortgage market today. According to the WSJ, banks are holding the lowest level of reserves to cover bad loans since 1990. With approximately $600 billion more adjustable rate mortgages to be reset to a higher market rate this year, two thirds of which are sub-prime, the risks for delinquencies and foreclosures are substantial. The market’s risk aversion is so high right not that even if tomorrow’s GDP, Chicago PMI or new home sales figures surprise to the upside, it may only have limited impact on the dollar.

Euro - The limited decline in the US dollar against the Euro confirms our belief that the major move in the markets today is primarily a liquidation of leveraged bets. Hawkish commentary by the central bank and stronger money supply figures continued to fuel gains in the currency pair. Remaining at a 17-year high, M3 rose by 9.8 percent year over year. The market was only looking for a mild rise of 9.5 percent. German CPI still accelerated in the month of February even though the rise was slightly softer than expected. This indicates that the Value Added Tax increase is finally revealing its impact on consumer prices, albeit a mild one. Separately, German retail manufacturing activity jumped slightly in the month of January, printing a 45 compared to last month’s 43.9. The Eurozone figures rose to 49.8 from 47.9. Despite the improvement, the contribution to the Euro was limited because the index still remained in contractionary territory. Looking ahead, Eurozone unemployment, German unemployment, Eurozone consumer confidence and consumer prices are all due for release. German retail sales were delayed to March 2nd. Improvements are expected in all of the reports, which should continue to give the European Central Bank reason to lift interest rates. Switzerland reported a stronger UBS consumption indicator. This suggests that we could also see stability in the KoF leading indicators report tomorrow.

British Pound – Interestingly enough, the GBP/USD, which is normally a very volatile currency pair had the tightest trading range today. There was no major data release which means that we will have to look ahead to tomorrow’s data, including both the consumer confidence survey and the Nationwide Housing price report for more direction. Expected to rise by 0.5 percent, housing prices are estimated to have bottomed slightly, lending to positive undertones in the UK economy. However, there is plenty of room for lower than expected actuals as mortgage applications data was less than exemplary in the London morning. Separately, consumer confidence is estimated to remain relatively close to last month’s results with median estimates anticipating a -8 reading. Lower figures are possible following the dour spending figures seen in the beginning of the month.

Japanese Yen – Movements in the Japanese Yen was the main focus today as the currency skyrocketed against everything in sight. Carry trade liquidation is in full force and usually when this happens, it is not just a one day affair. After having already made great profits being long the Dow and the short the Japanese Yen, leveraged traders may not be as easily willing to get back into the market at this point, especially given the risks that the US economy faces. In fact, the liquidation could exacerbate as more traders bail out of risky assets. Major players are getting stopped out of their long trades and we expect more to come. The Dow dropped 200 points intraday in a matter of minutes while USD/JPY dropped 100 pips in a blink of an eye. The quick and sharp reversal in the Dow and the far milder reversal in the dollar is clear indication that some big money was being stopped out.

Commodity Currencies (CAD, AUD, NZD) – The commodity currencies collapsed today on the back of carry trade liquidation in the high yielding currency pairs. Australian data was stronger than expected with new home sales rising for the second straight month. We heard encouraging words from the typically grim Costello who said that small businesses were more confident. New Zealand on the other hand reported softer inflationary numbers. The RBNZ followed up the report with a downward revision to inflation expectations. We could continue to see more liquidation out of the high yielders as we close in on the Japanese fiscal year end on March 31st.

 

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