By DailyFX – The meltdown in the financial markets continued as stocks finished down over 200 points, bond yields continued… … to slide and the US dollar rose as traders flocked to the safety of the mighty buck.

Although the economic data released today was stronger than expected, its
contribution to the dollar rally was limited since the move did not
fully begin until lunchtime. The lack of reaction stems from the
Federal Reserves inability to respond to the stronger trade and
inflation reports. Furthermore, these surprises were hardly surprising
given the recent weakness of the US dollar, which has pushed up both
exports and inflation. The markets priority at the moment is
figuring out how soon the Federal Reserve could lower interest rates.
Strong data only seems to delay the inevitable. Incidentally, over the
past few days, the Fed has injected approximately $64 billion of
liquidity into the banking system, the most since the September 11
attacks. This has been seen as the preliminary step to monetary easing,
especially if the blowups and losses in both the hedge fund and mortgage
sector do not subside. Interestingly enough, the Fed refrained from
adding liquidity today, which is the first time in 3 months that they
did not make any temporary repurchases of Treasuries from banks. This
comes after the Reserve Bank of Australia and Bank of Japan drained
liquidity from their banking system which suggests that the markets may
be returning back to normal, or at least thats how central bankers
feel. Overnight lending rates have moved drastically over the past few
days. A look back at the movements of overnight Fed Funds rates shortly
after 9/11, we see that interest rates normalized after 2 weeks. The
only thing that is preventing the Fed from raising rates is inflation,
which is why tomorrows consumer price data could be particularly
market moving. We continue to believe that the dollar will rise in the
short term but decline over the long term after the Federal Reserve
finally buckles down and admits the need for lowering interest rates.

Are Speculators Still Buying Carry Trades?

Nearly all of the Japanese yen crosses hit new 10 day lows on the back
of continued carry trade liquidation. With no major Japanese economic
data on the calendar, this breakdown is mostly due to todays triple
digit losses in the Dow. However interestingly enough, retail investors
continued to increase their long USD/JPY exposure according to the
latest FXCM Speculative Sentiment Index. Banks on the street are
reporting the same increased exposure by FX margin accounts. This
indicates that despite the sharp breakdowns seen over the past few
weeks, retail investors are not ready to give up on the trade that has
made them alot money over the past few years. From a price standpoint,
this means that if the sell-offs continue, the moves lower could be fast
and sharp as those who have gone long at current levels or higher get
stopped out. Meanwhile the VIX index of equity market volatility is up
again, indicating that risk aversion remains highs.

Australian, New Zealand and Canadian Dollars all See Sharp Losses

The New Zealand, Australian and Canadian dollars are the days
biggest market movers. All three of the commodity currencies are down
sharply due to the combination of weaker economic data and continued
flight to safety out of high yielding currencies back into the
greenback. The big surprise was in New Zealand, where retail sales
dropped for the second month in a row. Consumer spending is the
backbone of any economy which makes the recent weakness extremely
concerning. There are reports that over $3 billion of New Zealand bonds
are set to mature this month. Most New Zealand bonds are owned by
foreigners which suggest that the losses in the kiwi could exacerbate
when the bond investors repatriate their funds. Australian business
confidence was also weaker than expected in the month of July.
Australian companies are also being hit by the subprime debacle with
Rams Home Loans Group warning that profits would be weaker. Meanwhile
over in Canada, the combination of a weaker trade balance and news that
Coventree, the largest non-bank issuer of commercial paper in Canada was
forced to seek emergency funding when it failed to refinance debt that
matured yesterday.

Euro Drops to One Month Low, ECB Continues to Add Liquidity

The European Central Bank appears to be the only one still injecting
liquidity into the banking system and that too may becoming to an end
after ECB President Trichet said that conditions are returning back to
normal. The ECB has done a fantastic job of acting swiftly and
aggressively to the money market crisis. If liquidity injections do
come to an end, everyone will be asking whether rate cuts are next.
Eurozone economic data released this morning was all weaker than
expected with German GDP, French GDP, Eurozone GDP, and French consumer
prices all falling short of expectations. We continue to believe that
the ECB will raise interest rates in September but that rate hike will
be the central banks last. For all Euro traders, it will be
important to continue to keep an eye on Trichet for any signs of
reluctance towards a September rate hike.

Will the Bank of England Still Raise Interest Rates Now that Rates are
Below Target?

Like the Euro, the British pound dropped to a one month low against the
US dollar on the combination of broad dollar strength as well as weaker
UK economic data. Consumer prices dropped by 0.6 percent in the month
of July, pushing the British pound back below 2.0 for the first time in
seven weeks. Given the weakness in producer prices for the same month,
the market was already looking for a decrease in consumer prices, but
not one by this magnitude. However it seems that the drop in food prices
pushed the annualized pace of inflation growth below the Bank of
Englands 2 percent target for the first time since March 2006. The
Bank of England did not have this information at its last meeting which
means that it would not have had an impact on their hawkish inflation
bias. However the BoE has long been a very dynamic central bank and we
believe that the drop in inflation will make the most recent interest
rate hike the last.

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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