Carry Trades Continue to Sell Off as Dow Tumbles Below 13k on Red Letter Wednesday Big moves in the US… … stock markets are driving major losses in carry trades.

Most of the Japanese Yen crosses are down between 1 to 3
percent on the day with the losses in the carry basket that we are
monitoring, which consists of the three highest yielding currencies
against the three lowest yielding currencies quickly closing in on the
third biggest drawdown since the inception of the Euro. This was back
in May 2004, when the basket fell by 7.6 percent. With the exception of
the Japanese Yen, the dollar is up across the board as investors
continued to bail out of risky assets and move back to cash. Today is
known as the red letter day, which is the last opportunity that
investors have to request withdrawals by the end of September from hedge
funds, which usually subscribe to the standard 45 day redemption notice.
Given the recent volatility in the financial markets, many investors
will be looking to cut their losses and run. In order to meet these
withdrawals, hedge funds will need to raise cash. With many lenders
refusing to lend, the only way to raise cash would be through further
asset liquidation. Large scale redemptions could continue to weigh on
the equity and bond markets in the weeks to come. We are already seeing
the credit crunch have a wider impact on the financial sector. Deutsche
Bank and UBS were both downgraded by rival brokers. Countrywide
Financial was downgraded to a sell by Merrill Lynch who added salt to
the wound by warning that Countrywide could face bankruptcy. After not
injecting liquidity into the financial system on Tuesday, the Fed added
another $7 billion of temporary reserves today. Meanwhile a lot of US
economic data were released but that seemed to matter little to a market
that has already priced in an interest rate cut on September 18th.
Consumer price growth and industrial production were right in line with
expectations, foreign purchases of US securities was mixed, Empire State
was very hot, but the NAHB housing market index plunged to 16 year lows.
If the Federal Reserve needs an excuse to cut interest rates, they
probably already have one. More housing market data and the Philly Fed
survey are due for release tomorrow. The market will probably be
focusing more on housing starts and building permits than the
manufacturing sector index.

Japanese Yen Continues to Outperform All of the Majors

After being brutally beaten down over the past few years, the Japanese
Yen has returned with a vengeance. Like the Standard and Poors 500
Index, most of the Yen crosses have now erased all of its year to date
gains. The losses today have been extensive with AUD/JPY and NZD/JPY
both down over 2 percent. Yesterday, we indicated that retail traders
were still going long, but the new lows reached today have stopped many
of those traders out. Whether or not carry trades continue to sell off
will be partially dependent upon whether the Nikkei breaks lower tonight
as well. There is no major economic data due out from Japan this
evening. The turmoil in the markets has pushed the chances of an August
23 rate hike by the Bank of Japan from 37 percent yesterday down to 20
percent today. It will be interesting to see if the Bank of Japan
continues to add liquidity to the system as well. Finance Minister Omi
said last night that the worst of the home loan crisis may be over.

Sharp Losses Continue for the Australian, New Zealand and Canadian
Dollars

Next to the Japanese Yen crosses, the biggest losers were the
Australian, New Zealand and Canadian dollars. More Australian hedge
funds are being hit by the US subprime crisis. Basis Capital told
investors today that one of its hedge funds have lost over 80 percent of
its value. As of March, the fund had a $1 billion in holdings, which
means that now they probably now have less than $200 million. More
skeletons will probably becoming out of the closet as the hedge funds in
Australia prove to be up to their necks in risk. The New Zealand dollar
is tracking the Australian dollar lower, having sold off aggressively
for the past five trading days. The Canadian dollar also continued
lower on the back of continued weakness in economic data. We could see
a bounce in the CAD however after Coventree announced that they have
found buyers for their asset backed commercial paper, which suggests
that they may lift their funding freeze. The Bank of Canada also
injected further liquidity to calm the markets.

British Pound Slips as Bank of England Moves Further Away from Raising
Rates

The British pound dropped for the third straight day in a row after the
minutes from the latest Bank of England meeting revealed a unanimous
vote to keep interest rates unchanged. According to the minutes
“Most members emphasized that they had no firm view on whether
rates needed to rise further.” Rate hike expectations have already been
downgraded after the surprisingly soft consumer price report released
yesterday. The lack of support for a rate hike at the last meeting
pushes the central bank even further away from raising interest rates to
six percent by the end of the year. Do not be mistaken however as the
market has not given up on hope for another rate hike, especially after
Bank of England member Sentence stressed that one consumer price report
will not mean much to the BoE. Meanwhile UK employment data was
slightly worse than expected with average earnings including bonuses
declining in the month of June and jobless claims falling less than
expected.

Dollar Rally Takes Euro to Fresh Monthly Lows

Flight to safety continues to drive the US dollar higher against the
Euro. Over the past five trading days, the Euro has fallen close to 400
points. It appears that the European Central Banks attempts to calm
the markets have done little to ease market fears as bad news continues
to hit the headlines. Yesterday, ECB President Trichet said that
conditions are normalizing which explains why they did not inject
liquidity into the financial markets this morning. If another piece of
bad news hits the wires tomorrow, they may have to add more liquidity.

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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