NEWS / Fiscal Policy, Budget

Forex - Carry Trade Liquidation Hits the US Dollar

DailyFX Fundamentals 11-22-05

By Kathy Lien, Chief Strategist of www.dailyfx.com

??? Carry Trade Liquidation Hits the US Dollar
??? Euro Eyes 1.30, Looks Ahead to IFO
??? Japanese Yen Soars Despite Cabinets Downgrade of Economic Assessment

US Dollar ??“ Traders banked their four day rolls at the close of business yesterday and began a massive liquidation out of carry trades that sent the US dollar sliding to its lowest level against the Euro in 14 months. Just as everyone has settled into the notion that it would be a quiet trading week, volatility spiked and currencies began to move. Given that many US and Japanese traders have left early for the holidays, which is quite common this time of the year, the lack of significant liquidity is sure to have played a major role in today??™s exaggerated price action. The dollar??™s biggest drop was against the Swiss Franc and the Japanese Yen, both of which are very popular carry trades. Looking ahead, we want to warn that the combination of a depreciating dollar and a bleaker US economic outlook could resurrect talk of reserve diversification by central banks. This was the same case in 2004 when talk of reserve diversification was at its peak as the Euro surged from 1.22 to 1.3660 in a matter of 3.5 months. With the market so dollar bearish, any talk of reserve diversification could take the EUR/USD above 1.30. According to an interesting price study that we published as a special report today on DailyFX.com, over the past 20 years, the US dollar depreciated against the Euro 15 out of those 20 years during the month of December. The seasonality is even more apparent if we zoom into the past 12 years, where there were only two instances that the US dollar managed to rally in the last month of year. Meanwhile only minor economic data was released today. Weekly mortgage applications dropped last week by 3.7 percent, erasing most of the prior week??™s gains. Jobless claims ticked higher, bringing the 4 week average to 317k, which signals that payrolls could be a bit softer in November. The final University of Michigan consumer confidence index was also revised down from 92.3 to 92.1 as consumers were slightly less optimistic about the current economy.

Euro and Swiss Franc ??“ The Euro screamed higher today and came within an arm??™s length of the psychologically important 1.30 level. Economic data released this morning was mixed with French consumer spending falling short of expectations while Eurozone industrial orders dropped less than expected. France??™s economy has really been the laggard lately and we suspect that the latest bout of Euro strength will only do further damage to the fragile economy. For an export dependent region, the higher the EUR/USD rallies, the bigger the damage that the currency could do to the local economies. If you recall, the major reversal that we saw in the EUR/USD in late 2004 was triggered by a round of disappointing economic data. Although we may still have some more room to go in the EUR/USD on the upside before seeing a meaningful reversal, the odds of deteriorating economic activity are very high at this point. If the EUR/USD stays at its present level when the European Central Bank holds their monetary policy meeting, there is an extremely big possibility that ECB President Trichet will signal that the December rate hike is most likely their last. Even though the ECB is concerned about inflation, the strong currency also reduces inflationary pressures. The most important piece of economic data due for release tomorrow is the German IFO report on business sentiment. The prospects of an interest rate hike and the strength in the currency should lead to a drop in business confidence after a large jump last month. Meanwhile the market has had a strong demand for Swiss Francs over the past few days thanks to firmer economic data. Switzerland??™s labor market has been very tight and tomorrow??™s third quarter employment level is expected to confirm that.

British Pound ??“ The British pound scored big gains today despite a surprise voting record for the central bank??™s latest interest rate hike. The hike was originally expected to be supported by 8 of the 9 monetary policy members but only 7 actually voted in favor of it. Rachel Lomax joined David Blanchflower in voting to hold interest rates steady at 4.75 percent. They were both afraid that the previous rise in inflation was only temporary. The British pound sold off on the release, but quickly recovered its gains as the details of the minutes revealed a tinge of hawkishness that was not expected after the round of disappointing inflation reports. The monetary policy committee remained optimistic about growth, which we expected after the Quarterly Inflation report, but on the inflation front, they talked mostly about the upside risks and how the tight labor market, high money supply and strong housing market could push inflation even higher. The fact that the British pound is quickly closing its yield differential with the US dollar has helped the pair stage today??™s impressive rally.

Japanese Yen ??“ Carry trade liquidation was the main driver of today??™s rally in the Japanese Yen. No meaningful economic data was released last night and the market completely shrugged off the Japanese Cabinet??™s first downgrade of their economic assessment since December 2004. The government is worried about consumer spending which has long been one of Japan??™s major economic problems. The prior weakness in the Yen should help to keep demand domestic while also boosting the export sector. We still believe that Japan is on the road to recovery and expect incoming economic data to reflect that. Japanese markets are closed tonight for the country??™s Labor Thanksgiving Day.

Commodity Currencies (CAD, AUD, NZD) ??“ The commodity currencies continued to strengthen today thanks to the broad based weakness in the US dollar. Canada was the commodity dependent country that had economic data released today, which was slightly worse than expected. Consumer prices fell for the second month in a row with the annualized pace of growth increasing from 0.7 percent to a less than expected 0.9 percent. The core rate hit a 3.5 year high however, offsetting a bit of the bearishness by indicating that inflationary pressures are still prevalent. There was no economic data released from Australia or New Zealand. Firmer gold prices and bids for Qantas Airways are helping to extend gains in the Australian dollar.