By DailyFX – Currency, Equities and Bond Markets All Have the Same Hope for the FOMC Tomorrow Equities, bond yields… … and the US dollar are all higher today indicating
that the markets are collectively hoping for some reassurance from the Federal Reserve tomorrow.

The turmoil in the mortgage market has
everyone worried that the worst has yet to come, but if the Fed still
feels that the economy will continue to expand at a moderate pace
over the coming quarters, and the upside risks to inflation is a
bigger problem than the downside risk to growth, then the rest of us may
be able to relax as well. The Dow has recovered all of Fridays
losses but the most unique aspect of todays move was the fact that
bond yields rallied as well. Over the past few weeks, when bond yields
refused to follow stocks higher, the rally in equities was short lived.
Of course, the Feds words could change everything, but todays move
suggests that the dollar, bond yields and equities could extend their
rise going into the FOMC rate decision. Once again, the statement will
be the main focus since the Fed is not expected to lower interest rates.
Although the market is pricing in a 100 percent chance of a rate cut by
the end of the year, they are expecting the cut in the fourth quarter.
Yet, cautionary comments from the Fed are very possible. At his
semi-annual testimony on the economy and monetary policy, Fed Chairman
Ben Bernanke warned that things will get worse before they get better.
Although it has already gotten worse since then, the chances that the
problems will become even more severe still exist. Part of the Fed’s
job is to ensure stability in the banking sector and Bernanke does not
want to make the mistake of downplaying what could later be a serious
economic problem. Then again, as recently as this past Thursday, Fed
Governor Kroszer also said that we have not seen subprime have “an
effect on the broader economy. If the Fed was to do what the market
has already decided for them, which is to lower rates by the end of the
year, they will eventually need to adjust their tone from hawkish to
neutral to dovish. Tomorrow would be a good chance for them to do so.

Carry Trades Rebound as Dow Sees Biggest Percentage Rise in 4 Years
On a percentage basis, the move in the Dow today was the strongest
since April 2003. The market cared little about news that American Home
Financial has filed for bankruptcy since that seemed inevitable after
the mortgage lender laid off 90 percent of its workforce on Friday.
Although the drop in oil prices could be partially credited for the
rebound in the Dow, the late afternoon surge seemed to be driven by
nothing more than a relief rally. The VIX index, which is a measure of
the volatility in the equity market plunged significantly after hitting
a new 52 week high. If the Federal Reserve does not say anything
entirely bearish, then we could see further gains in both the Dow and in
carry trades which have been moving tick for tick with US equities.
With no major Japanese economic data until the end of the week, this has
been the primary driver of todays recovery in the Yen crosses. The
rebound in USD/JPY is particularly impressive since the currency broke
below 118 and hit a fresh 4 month low in early Asian trading. At that
time, the losses in carry matched the March sell-off.

British Pound Hit by Foot and Mouth Disease Outbreak
The British pound has been weak even before the US stock market and US
dollar took off because of an outbreak of Foot and Mouth disease in the
UK this weekend. The last time this epidemic hit the country was back
in 2001 when the economic impact was close to GBP10 billion. At that
time, not only was the British meat shut out of the international
markets, but tourism was also seriously affected. Between the spring
and summer of 2001, the British pound fell from 1.4750 to 1.3680, which
is over 1000 pips. Although the UK government is doing all that they
can to contain the outbreak, the US, Japan and EU have already banned
imports of live animals, fresh meat and milk from the UK. To some
degree, this must have a negative impact on the UK economy and that
inevitability is being reflected in the British pound today. Even
though the Bank of England will be delivering their Quarterly Inflation
report on Wednesday, the FMD breakout could curtail any further pound
strength.

Euro Falls Short of Hitting its Record High
The Euro came within a hair shy of hitting its all time high of 1.3852.
Much stronger than expected German factory orders and demand for
EUR/JPY has helped the EUR/USD hold steady despite a strong rally in US
stocks and US bond yields. The market was looking for factory orders to
retrace after rising strongly in May. However the strong Euro seems to
have only a limited impact on demand since orders increased 4.6 percent
which compares to the markets -0.6 percent forecast. This suggests
that Tuesdays industrial production numbers could also be firm.
Trichet installed a strong bid tone in the currency last week when he
held a surprise press conference to announce to that they essentially
plan on raising rates next month. In an environment where the US is on
the verge of lowering rates, this has become very bullish for the Euro
at the expense of the US dollar.

Australian, Canadian and New Zealand Dollars All Up Strongly
The Australian, New Zealand and Canadian dollars are all up strongly
today despite the drop in both oil and gold prices. New Zealand labor
costs increased more than expected in the second quarter, which suggests
that the labor market remains tight. Actual employment data will be
released later this week. Australian ANZ job advertisements fell by 0.5
percent, but the market is still looking for a nice rebound in jobs last
month. Before we get that data however, we have the Reserve Bank of
Australia interest rate decision. The market is pricing in a quarter
point rate hike tomorrow night. When the central bank raises rates,
they also release a statement. The high level of inflation suggests
that the RBA could still raise rates again this year, but they will
probably pause given global economic conditions.

DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com

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