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Wednesday August 1, 2007 - 21:46:12 GMT

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Forex - British Pound Rallies into BoE Rate Decision

DailyFX Fundamentals 08-01-07

By Kathy Lien, Chief Strategist of

•    US Dollar:  Volatility Continues to Rise as Equities See another Roller Coaster Ride
•    British Pound Rallies into BoE Rate Decision
•    ECB:  No Surprise Press Conference Expected

US Dollar:  Volatility Continues to Rise as Equities See another Roller Coaster Ride

August is typically a month where most people expect quiet summer ranges.  However this year, even those who have the luxury of enjoying the entire month off may not be sitting pretty.  Volatility has rocked the markets and no asset has been spared including stocks, bonds and oil prices.  The Dow went from being up close to 100 points to down over 70 before settling back up 150 points. Oil prices also hit fresh all time highs before reversing sharply.  This rollercoaster price action pushed the Chicago Board Options Exchanges’ market volatility index or VIX to a 1 year high today.  Although it later retraced, the last time we saw the VIX at that level was back in 2006, which was also when we saw the biggest case of carry trade liquidation in 20 years.  The drawdown in carry trades at the time was 13 percent, double what we have seen so far.  There is no real explanation for the late afternoon recovery in US equities.  Instead, hedge funds have reported more losses.  Bear Stearns announced today that they have blocked withdrawals from a third hedge fund and there were also reports that Caxton Associates was being forced to cut exposure due to margin calls from JPMorgan Chase and Goldman Sachs. As for economic data, ADP reported much weaker private sector employment, Challenger reported more layoffs while manufacturing growth slowed nationally in the month of July.   Even though the ADP number was quite bad, they overshot private sector employment by 50k last month, which suggests that the drop in July could simply be a reversal.  The one piece of good news was the rise in pending home sales.  After falling by 3.7 percent in May, sales increased by 5 percent to a 3 year high.  Unfortunately sales were still below year ago levels and was offset by the fact that mortgage approvals hit a 5 month low, indicating that the housing market has yet to stabilize.  There were also rumors today that Beazer homes may have to report bankruptcy.  Although denied, we would not be surprised if bankruptcies become the trend.  In the meantime, any rebound in the Dow and carry trades will probably have a difficult time recovering even half of its recent losses.  

British Pound Rallies into BoE Rate Decision

The Bank of England is expected to leave interest rates on hold tomorrow, but the rally in the British pound over the past few days suggests that some traders may be holding out for a surprise move.  Compared to the rest of the world, the UK economy is certainly standing on stronger footing.  Today, manufacturing PMI surged to a 3 year high, which comes in sharp contrast to the deterioration in the US ISM index.  Output prices hit the highest level in 15 years, indicating that inflation is still a big concern while employment rose to a 3 year high.  Even if they do not raise rates, this suggests that Bank of England Governor King will continue to hold onto his hawkish bias when he delivers their Quarterly Inflation report next week.  

ECB:  No Surprise Press Conference Expected

Despite the volatility in the rest of the foreign exchange market, the Euro traded in a tight range.  Slower manufacturing sector growth in Germany and France did not stop the final Eurozone PMI numbers from coming out stronger than expected.  This however should have little impact on the ECB’s interest rate decision tomorrow.  They are expected to leave rates unchanged at 4.00 percent.  There is a slim chance that the central bank could hold a surprise press conference but given the volatility in the global equity markets, we think that this is extremely unlikely.  However if they do, this means that inflation is such a big concern that they cannot afford to relax.  It would also signal that they fully plan on raising interest rates when they return from their holidays in September.  Alternatively, if they do not hold a press conference, then that could mean another rate hike will not come until October.

Canadian, Australian, New Zealand Dollars Holds Onto Gains

The Canadian, Australian and New Zealand dollars all rebounded strongly today.  The CAD rallied throughout the European and US trading session despite the reversal in oil prices.  Most of this movement was related to flow since there was no economic data released and comments from Finance Minister Flaherty last night was bearish.   He said Canada was seeing a little spill over from the US sub-prime mortgage crisis. The Australian and New Zealand dollars are also stronger thanks to the sharp increase in Australian retail sales last month and a nice rise in the manufacturing PMI index.  Originally expected to increase by 1.0 percent, sales rose 1.4 percent.  The Australian trade deficit however came under the weight of the stronger Aussie as exports decreased while imports increased.  There are no further releases from Canada, Australia, and New Zealand until Friday.  

Short Term Reversal in the Yen Crosses

The Yen crosses reversed sharply on the back of the rebound in the Dow.  The biggest winners were CAD/JPY, NZD/JPY and AUD/JPY.  The long wicks on each of the yen crosses suggest that we could see a further rebound over the next 24 hours especially since the Dow found support today at the same level that it did back in June, which makes this a potential triple bottom.  Carry trades thrive in a low volatility environment.  Although the VIX hit a 1 year high intraday, it closed up marginally.  Bottom pickers need to be careful however since intraday surprises in the Dow have become the norm. All it takes is another major blowup by a hedge fund or mortgage lender and a technically sound scenario could become completely invalidated.  Keep watching the Dow in the meantime since the Yen crosses are moving in lockstep with the equity index.  For a clue on how the US market could behave, watch Asian stocks tonight.

DailyFX Research Team
Forex Capital Markets LLC
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