By DailyFX – Stocks rebounded today taking carry trades higher in the process as central banks around the world continued… … to inject liquidity into the financial markets.

Although the bounce in equities and currencies stirs
some optimism, the movements in the currency and stock markets can often
times be distorting as well. The bond and interest rate markets tend to
be the most accurate reflection of the markets optimism and
pessimism. Therefore todays sharp drop in one month and three month
Treasury bill yields suggest that the Federal Reserves discount rate
cut on Friday has not completely stabilized the markets, especially
since one month yields hit a 3 year low. Last week, economists were
comparing the moves to October 1998, but today they are comparing the
moves to the stock market crash of 1987. This goes to show how severe
recent movements have become. Investors are flocking to the safety of
short term US government debt as liquidity continues to dry up in money
market funds and commercial paper. The fear of further credit problems
has made principal protection everyones top focus especially for
money market funds that need to find a new place to invest after
liquidity dried up in the commercial paper market. Therefore even
though we could see a continual recovery in the Dow, further gains may
be limited to another 150 points. Federal Reserve Chairman Ben
Bernanke, US Treasury Secretary Paulson and Senate Banking Committee
Chairman Christopher Dodd will be holding a closed door meeting tomorrow
to discuss the recent volatility in the financial markets and its
implications for the broader US economy. Bernanke will probably come
under pressure to do more to stabilize the economy and the housing
sector. Although there are a few other intermediate options like
foreign currency swaps, altering collateral requirements and lending
directly to banks, only a cut of the Fed Funds target rate will satisfy
the markets. Although there will be speculation of an inter-meeting rate
cut, we think that this is unlikely. Instead, what is more likely would
be a lifting of portfolio caps on Fannie and Freddie which would help to
bring some bids back into the bond market. Meanwhile the only piece of
US economic data released today was leading indicators, which came out
right in line with expectations.

Further Weakness in Yen Crosses Will Depend on the Nikkei

After the sharp recovery on Friday, it was hardly surprising to see the
Japanese Yen crosses rally today. The rebound has been mild for the
most part as many currency pairs fail to recapture Thursdays
breakdown point. The first test of whether these rallies will continue
will be in Asia. It took some time Sunday night for the Nikkei to
respond to the recovery in the Dow on Thursday and even then the
Japanese stock market ended much lower than its intraday high. This
type of price action suggests that Japanese traders, like many US
traders dont believe that the worst is behind us but they are
relieved that central banks continue be actively trying to help
normalize the markets. The Bank of Japan added one trillion yen to its
short term money markets today. The continual liquidity injections by
the Japanese clearly indicate that they will not be hiking interest
rates later this week. Furthermore the recent strength of the Japanese
Yen is also doing its part with regards to tightening the economy. In
the meantime, the Yen crosses are driven less by interest rate
expectations for Japan and more by the markets overall risk appetite.

British Pound Rallies on Stronger UK Economic Data

The British pound outperformed both the US dollar and the Euro today
thanks to stronger economic data. Rightmove house prices, money supply,
BBA mortgage approvals and public finances all came out stronger than
expected. This suggests that domestic demand remains robust while the
housing market remains stable. This stability may be one the main
reasons why the Bank of England has not felt pressured to add liquidity
in the financial markets. There has been a lot of talk that the Royal
Bank of Scotlands bid for ABN Amro could be in jeopardy after the
recent credit problems. The fear is that the consortium extending the
bid may have problems raising cash from investors who may be licking
their own wounds after this past weeks troubles. If the bid is
abandoned and no other buyer steps up to plate, this could be negative
for the British pound in the near term for no reason other than sheer
disappointment.

Canadian Dollar in Play on Tuesday

The Canadian dollar will be in play tomorrow with consumer prices,
leading indicators and retail sales due for release. The economic data
is expected to be mixed with economists calling for an increase in
consumer prices and leading indicators, but a decrease in retail sales.
The price action of the Canadian dollar today suggests that traders may
actually be positioning for stronger numbers. The Canadian government
has been out in force trying to calm the financial markets. Canadian
Finance Minister Flaherty said today that the country is strong enough
to get through the temporary impact of the global markets re-pricing
of risk; we hope this is true. Meanwhile the Australian dollar is up
strongly today while the New Zealand dollar trailed behind due to the
drop in New Zealand visitor arrivals and producer prices.

Euro Consolidates Ahead of German ZEW Survey

The Euro ended the day unchanged against the US dollar as the market
tries to figure out whether the European Central Bank will continue to
press forward with raising interest rates next month. The guessing game
will be helped by tomorrows German ZEW report, which tends to be one
of the more market moving reports for the Euro. Given the turmoil in
the financial markets, we expect analyst sentiment to deteriorate
significantly. With no meaningful US data on the calendar, the German
ZEW could be a bigger than usual market mover. Meanwhile over in
Switzerland, producer and import prices were weaker than expected but
this has had a limited impact on the Franc.

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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