By DailyFX – Volatility continues to rule the financial markets with the Dow rallying, retracing and then rallying once again.The… … yen crosses followed suit but the pullbacks were less severe.

This type of volatility in the markets represents significant two way action and a
great deal of uncertainty on behalf of traders and investors. The
biggest news in the financial markets today was Chinas threat to dump
US Treasuries and US dollars. Both the US dollar and bond prices have
sold off drastically on the news even though we expect this to be
nothing more than empty threats (See our Special Report for more
details) since China and the US are interdependent. Treasury Secretary
Paulson made a special appearance on CNBC to refute fears that China has
the power to rattle the US markets. President Bush did the same on Fox
News, indicating either how serious the government is taking the
potential threat or their concern about the stability of the financial
markets. This caused the reversal of stock market gains, but stocks
regained their momentum after Bush reassured the markets that the US
economy can deal with market volatility and therefore they did not feel
that Fannie Mae needed to be bailed out at this point. The dollar is
stronger today against the Japanese Yen, but weaker against every other
major currency. In fact, the dollar is slipping back towards its record
lows against the Euro. Part of the reason for the dollars weakness
today was due to Chinas announcement, but the other contributing
factor is the commitment by other central banks to continue raising
interest rates. This morning, hawkish comments by Bank of England
Governor King pretty much guaranteed 6 percent rates by the end of the
year. The Reserve Bank of Australia raised interest rates last night
and left the possibility of another hike by Christmas. Last week the
ECB held a special press conference just to tell the world that despite
the recent fluctuation in the markets, they still plan on raising rates
next month. In contrast, in the US, it is not just a matter of if, but
a matter of when the Federal Reserve will announce its plans to cut
interest rates. The clear divergence between what the Fed and every
other central bank is doing is a big reason why the dollar not only
weakened today, but could continue to weaken in the days to come.
Meanwhile there was good news on the data front. Wholesale inventories,
wholesale sales and mortgage applications all increased more than
expected. The big rise in wholesale sales suggests that we could see an
upward revision to second quarter GDP.

Are Carry Trades Back?

Carry trades continued to track the US stock market tick for tick.
Today, impressive rallies were seen in all of the Yen crosses, raising
the question of whether carry trading is back. Although it may be
tempting to say that it is because we could see a bit more strength in
pairs like AUD/JPY, USD/JPY and GBP/JPY, the market environment has
changed significantly over the past few weeks. The age of easy money is
over with many leveraged buyout deals and plans for stock buybacks
cancelled. These were the primary drivers of equity market strength in
the first half of the year and their disappearance will make it much
more difficult for the Dow to return to its record highs. If the Dow
fails to rally back towards its prior highs, then carry trades will
probably not see new multiyear highs either. Furthermore, carry trades
thrive in low volatility environments and the recent intraday moves in
US stocks is anything but low volatility. With harsh lessons learned
over the past few weeks, speculators will be far more cautious about
assuming risk in the months to come. Standard and Poors warned today
that they may cut ratings for more than $900 million Alt-A bonds, which
means that now is not the time to become complacent. Although Japanese
economic data continues to be weak, it will have a more of a secondary
impact on the Yen crosses.

British Pound Rallies in Anticipation of 6 Percent Interest Rates from
Bank of England

After being dragged down by the outbreak of Foot and Mouth disease, the
British Pound powered back today on the strong likelihood that the Bank
of England will be raising interest rates by at least 25bp over the next
few months. In their Quarterly Inflation Report, the BoE pointed out
that rising oil and food prices will keep inflation above their target
for the next 2 years. If they do not fall, then the upside risk to
inflation would be crystallizing. The continued hawkishness of
the BoE will be positive for the GBP/USD and negative for EUR/GBP. UK
trade balance is due for release tomorrow morning. The strength of the
British pound should weigh on exports.

Reserve Bank of Australia Raises Interest Rates, Remains Hawkish;
Employment Reports Up Next

The Australian dollar rallied today on the combination of US dollar
weakness and hawkish comments from the Reserve Bank of Australia. The
central bank raised interest rates to 6.50 percent last night, which was
widely expected but their degree of hawkishness hinted at the
possibility of another rate hike by the end of the year. This helped to
rally both the Australian and New Zealand dollars. Employment reports
are expected from both countries tonight; the labor market should
continue to remain tight. The Canadian dollar also strengthened on the
back of US dollar weakness. They have housing market reports due out
tomorrow.

Euro Heads Back Towards Record Highs

The Euro came within a 30 pips of its all-time highs today on the back
broad dollar weakness. Both the German and French trade balance was
weaker than expected in the month of June. The French trade deficit
remained unchanged at -3 billion while the German trade deficit shrunk
from 17.3 billion to 16.5 billion. The current account balance for the
same month however was much stronger than expected, at 16.6 billion
versus 8.9 billion the prior month thanks to an increase in both exports
and imports. Meanwhile the economic conditions in Switzerland continue
to be good with the unemployment rate remaining at an extremely low 2.7
percent. This has helped the franc outperform the Japanese Yen.

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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