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Forex Carry Trades Liquidation: How Bad Can it Get?

DailyFX Fundamentals 07-31-07

By Kathy Lien, Chief Strategist of DailyFX.com

•    US Dollar:  More Problems Equals More Losses
•    Carry Trades Liquidation: How Bad Can it Get?
•    British Pound - The Only Currency to Rally against the Dollar

US Dollar:  More Problems Equals More Losses

The markets are selling off once again as the troubles in the sub-prime sector continue to grow.  Yesterday, everyone ignored news that American Home Mortgage (which commands 2.5 percent of the mortgage market) had to delay its dividend but today, the double blow of major losses at Sowood Capital and C-BASS was too much for them to handle.  The Dow went from being up 135 points in the early US trading session to down 146 points at the market close. This was a swing of 281 points on an intraday basis.  Unsurprisingly, bond yields and carry trades have also sold off while the VIX index resumed its rise, indicating the return of risk aversion. Economic data is also beginning to deteriorate.  Aside from consumer confidence, every piece of US economic data released today was weaker than expected.  On a growth front, personal income was unchanged in the month of June while spending slowed.  In terms of inflation, the market was looking for the monthly core PCE deflator to increase, but instead, it remained unchanged.  House prices and construction spending deteriorated as well but the big surprise today was the sharp decline in the Chicago PMI index and the jump in consumer confidence.  Despite continued weakness in the US dollar, regionally, growth in the manufacturing sector is beginning to slow.  With both the Philly Fed and Chicago PMI index dropping significantly, tomorrow’s national manufacturing index (ISM) will likely follow suit.  Do not be too discouraged however as things may actually get better at the end of the week.  According to the “Jobs Plentiful less Hard to Get” category in the consumer confidence report and the employment component of the Chicago PMI, non-farm payrolls due out Friday could actually be firm since both increased sharply. Whether or not this will overshadow any further losses in the subprime sector remains to be seen.  Contrary to what some people may think, the Fed IS watching the stock market.  President Poole hinted today that the central bank is watching the markets closely and will act “in due time if and when evidence accumulates that action is appropriate.”  That would involve deterioration in both inflation and employment, which makes keeping an eye on NFPs even more important.  

Carry Trades Liquidation: How Bad Can it Get?

Carry trades have sold off significantly over the past few weeks with GBP/JPY being the biggest loser. Having fallen from a high of 251.15 down to its current level of 241, it only took six trading days for the currency pair to erase the 1000 pip rally that was 3 months in the making.  NZD/JPY, AUD/JPY and CAD/JPY all suffered the same fate, having each registered over 700 points in losses.  As one of the most popular and successful trading strategies over the past few years, the strength of recent losses has caught everyone by surprise.  To the dismay of Mrs. Watanabe and anyone still long carry this is not the worse case of carry trade liquidation that we have seen.  Between December 2005 and June 2006, our Dynamic Carry Trade basket had a drawdown of as much as 13 percent.  From its peak last Monday, the portfolio is down 7 percent.  There is still more room to fall before we get to 13 percent, which is the biggest drawdown that the portfolio has seen over the 20 past years.  The idea of long carry is breaking down and if the Asian markets finally follow suit, which they haven’t in the past week that could be the trigger for further losses.  Last night’s Japanese data was mixed.  Labor cash earnings, overall household spending, and the PMI index all weakened, but the jobless rate and housing starts improved.  With no more significant Japanese data on the calendar this week, the fate of the Yen will continued to be determined by the movements in the Dow.

British Pound - The Only Currency to Rally against the Dollar

The British pound was the only currency to rally against the US dollar today thanks to the fact that the FTSE saw the biggest gain in 14 months.  The rally was triggered by strong earnings and rumors that the UK’s seventh-largest bank could receive a buyout offer from the National Bank of Australia.  Merger and acquisition flow has often come to the support of the currency therefore it is not a surprise to see it do so again.  Economic data released this morning was mixed.  Consumer confidence deteriorated but even though the expectations portion of the CBI Industrial Trades survey dropped for August, the realized component of the report improved modestly.  In an environment where the economic outlook for the US is deteriorating quickly, the relative stability of the UK economy and the continual M&A flow will help the British pound outperform the US dollar.  

Canadian Dollar Weakens Despite Record Close in Oil Prices, Kiwi Sells off as Government Warns of Further Losses

The Canadian dollar continued to sell-off today despite the fact that crude oil futures closed at a record high.  Concerns about inventory and potential demand has weighed on the liquid commodity.  The lack of reaction in the Canadian dollar suggest that the market is far more concerned about the contagion affect of weaker US growth.  GDP fell short of expectations in the month of May despite stronger retail sales.  Canadian companies are also beginning to report weaker earnings as a direct result of the strong loonie. Meanwhile the New Zealand dollar is down sharply after the foreign minister indicated that the currency has room to fall another 27 percent.  Whenever a price targets is given, the markets are never happy.  Australian retail sales is due for release tonight and they are expected to rebound sharply after the drop in May.  

Euro Sells Off as Investors Flock to the Safety of the Dollar

A flight to safety has pushed the Euro lower against the US dollar today.  Economic data was mixed with German retail sales increasing less than expected on a monthly basis but more than expected on an annualized basis.  The number of people unemployed also dropped, which is promising.  However there is not information to tell whether the ECB will raise rates in September or October.  

 

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