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Forex - US Dollar – Carry Trade Liquidation Continues to Drive Market Fluctuations

FXCM DailyFX Fundamentals 03-05-07

By Kathy Lien, Chief Strategist of DailyFX.com

• US Dollar – Carry Trade Liquidation Continues to Drive Market Fluctuations
• Euro Slips on Speculation that ECB Will Move to Neutral
• Australia and Canada Report Strong Service Sector PMI

US Dollar

It certainly feels like déjà vu as last week’s trends in the currency market manifest themselves again. When the markets reopened on Sunday evening, the Japanese Yen resumed its climb against everything in sight. The dollar fell victim to Yen strength as it dropped just a hair shy of its 3 month low. However the dollar’s weakness was just limited to the Yen as the greenback actually staged an impressive rally against currencies such as the British pound, Australian and New Zealand dollars. The market completely shrugged off the drop in the service sector ISM report despite its deterioration to a 2003 low. The details of the report are not as discouraging as the headline with only 5 of the 9 sub-indices reporting slower growth. Nonetheless, the service sector is a far bigger contributor to US growth than the manufacturing sector. Today’s drop in the February report negates the improvement that we saw in the manufacturing sector ISM last week. The data also indicates that the weakness in the other parts of the economy is hitting the service sector as well. With non-farm payrolls due out this Friday, it is important to note that the employment component of the service sector report picked up in the month of February; this follows a similar improvement in the manufacturing survey. Many of the large banks are calling for a far weaker NFP print than the current 100k forecast. Part of that pessimism can be attributed to the larger number of jobless claims that have reported over the past few weeks. In the meantime, contributing to the dollar’s strength today were relatively optimistic comments from Fed Presidents Warsch and Poole. Both of the Presidents attempted to down play the recent volatility in the stock markets and talked up the economy’s resilience. We would not be surprised to see more Fed officials attempt to pacify the markets, but the Fed may be forced to cut interest rates sooner rather than later if the Dow does not stop falling.

Euro

The Euro has seen its biggest one day move in over a month on the back of carry trade liquidation hitting EUR/JPY, weaker service sector PMI and broad dollar strength. Although service sector activity accelerated in France and Italy during the month of February, it deteriorated significantly in Germany, which is the region’s largest economy. We are beginning to see the effect of the VAT tax increase on German consumer spending, but with the regional index still well in expansionary territory, this will not prevent the European Central Bank from lifting interest rates again later this week. However it could very well push the central bank back into neutral territory. With the sharp increases in volatility throughout the financial markets and the threat of a slowdown in the US, the ECB may opt to take the backseat until the markets calm down. They may not want to exacerbate the slides that we have already seen in the European markets. Since last Monday, the German DAX is already down close to 8 percent. The US calendar is very light tomorrow which leaves Eurozone retail sales and the European Commission’s GDP forecasts as the market’s primary focus. Switzerland will be releasing its fourth quarter GDP report tomorrow. Strength has been seen in nearly all of Switzerland’s latest economic reports, which confirms the market’s forecast for stronger growth.

British Pound

The British Pound plunged across the board as carry trade unwinding during the Asian session dragged Cable down nearly 200 points from Friday’s New York close. Economic data out of the UK did little to boost the currency, as PMI services tumbled to a five-month low of 57.4 from 59.2 during the month prior. All of the index components slipped, including employment, outstanding business, prices charges, and business expectations. The biggest decline came from new business expectations, which hit the lowest level since November 2005 and bodes particularly ill for the sector. The remainder of the week will be relatively quiet, though HBOS house prices, BRC retail sales, and Nationwide consumer confidence are all estimated to weaken. The BOE rate announcement on Thursday will likely be a non-event, as the central bank is expected to leave rates steady and do not normally comment on their decision until the release of the policy statement later in the month.

Japanese Yen

The liquidation of Yen crosses continues as the Japanese Yen sees another day of impressive gains. The sell-off started as soon as the markets opened in the Asian session on Sunday evening and was triggered by the sharp increase in capital spending in the fourth quarter. Strong profitability in 2006 has provided corporations with the excess capital that they need to spend in both manufacturing and non-manufacturing investment. The Yen’s rally was further exacerbated by the revaluation comments from China’s PBoC Governor Zhou. He said that they will be widening the currency’s trading band, although a time table was not given. The sharp moves that we have seen in the Yen indicate that there are many factors contributing to the currency’s rally. This includes repatriation, carry trade liquidation and speculators stopped out.

Commodity Currencies (CAD, AUD, NZD)

The Commodity Currencies are weaker across the board as the high-yielding Australian dollar and New Zealand dollar continue to feel the wrath of carry trade unwinding. In fact, Australian data was actually quite bullish for the national currency while the New Zealand calendar was empty. The AiG Performance of Services Index surged to 54.5 from 49.5 – signaling expansion in the sector for the first time in four months. Meanwhile, the TD Securities Inflation Index pointed to building price pressures as the figure accelerated 0.2 percent for the month and 3.4 percent year over year. In Canada, Ivey PMI surged to a seven month high of 62.2 from 53.8 during the month prior. A breakdown of the data shows that nearly all of the components improved, with the employment index edging back above 50 while the price index jumped to the highest level since August 2006. With the sector performing well once again and last Friday's release of Q4 GDP hotter than expected at 1.4%, Canadian expansion appears to be on a steady track and should keep the Bank of Canada maintaining a neutral bias at their MPC meeting this week.

 

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