Safe Haven Bid Helps Dollar as Markets Wait for the Next Shoe to Drop. The foreign exchange and currency markets… … are finally feeling the fallout from yesterdays sharp move in Treasury bill yields.

We had warned in Daily Fundamentals that the rally in carry trades and the Dow
could be distorting and that the bond market tends to have the most
accurate reflection of investor sentiment. With the yields on Treasury
bonds falling once again, it is clear that the market is not entirely
convinced that the Federal Reserve has done enough. Money markets have
recovered a bit after Mondays dramatic losses but investors are
continually willing to accept lower yield for the safety of principal
protection. The market is also disappointed by the fact that nothing
significant came out of the closed door meeting held by Federal Reserve
Chairman Ben Bernanke, US Treasury Secretary Paulson and Senate Banking
Committee Chairman Christopher Dodd this morning. Dodd held a press
conference after the meeting where he simply stated that Bernanke has
pledged to use all the tools at his disposal to stabilize the
financial markets. We are sure that this was his intention all along,
the only question is, how soon he would bring out the ultimate tool in
his arsenal which is an interest rate cut. The market is currently
pricing in 75bp of easing by the end of the year but there has even been
speculation of an intermeeting rate cut or 50bp of easing in September.
Interestingly enough, on a day that the Fed cut the minimum fee for its
securities lending program to lower the hurdle for borrowing, Richmond
Federal Reserve President Lacker said that financial market
volatility, in of itself, does not require a change in the target
federal funds rate. Over the past year, he has consistently leaned
towards higher interest rates. We are sure that most market
participants are glad that he is not a voter of the FOMC this year. The
financial markets are now waiting for the next shoe to drop. Whether a
move by the Fed comes first or another hedge fund or mortgage lender
blowup will determine where the dollar is headed next. Meanwhile keep
an eye on tomorrows initial claims report. A big increase could
raise speculation that job growth in August will be very weak.

Demand for Carry Trades Remain Low at Current Levels

The narrower trading ranges in the Japanese Yen crosses indicate that
the volatility in carry trades is beginning to taper off. Even though
all of the yen crosses are lower today, they have not fallen below
Mondays low. A drop in volatility is confirmed by the fact that the
VIX has fallen more than 30 percent since hitting a four year high last
week. Lower volatility usually helps carry trades, but in an
environment where investors are scrambling for cash, interest in carry
remains limited. On the interbank level, we have heard that FX margin
traders (their fancy term for individual traders) are beginning to snap
up value (in carry trades) at current levels. According to our FXCM
Speculative Sentiment Index however, that is not the case. Even though
we have seen traders initiate new USD/JPY positions on Monday and
Tuesday, the bulk of the increase is actually in short USD/JPY exposure
and not long. Meanwhile, the chances for an interest rate hike by the
Bank of Japan later this week is still at zero. The Bank of Japan
continued to inject liquidity into the financial system last night which
is a sign that they remain committed to keeping monetary policy easy.
The one piece of Japanese data last night was the all industry activity
index, which was weaker than expected in the month of June.

British Pound Hit by Fear that the Next Big Blowup Could be in the UK

The British pound under performed both the Euro and US dollar today on
concerns that the next big subprime blowup could be in the UK. There
has also been talk that a UK hedge fund or insurance company could be in
trouble. The Bank of England also confirmed that a UK bank (possibly
Barclays) used the standby facility at a penalty rate of 6.75 percent to
cover a shortfall in funding. This is the first time that the emerging
lending facility has been tapped since the beginning of the subprime
crisis. As the problems grow, so will expectations that the Bank of
England will keep interest rates unchanged for the remainder of the
year.

German ZEW Survey Hits 8 Month Low Supporting Call for Unchanged Rates
in September

With the subprime debacle, it is hardly surprising to see the German
ZEW survey fall below expectations in the month of August. The Eurozone
economy as a whole, particularly Germany has been and will continue to
be vulnerable to financial sector losses, which is part of the reason
why analyst sentiment has deteriorated. This supports the call by some
economists for the ECB to leave interest rates unchanged next month. We
havent heard much from ECB President Trichet over the past few days
and we are sure that he is closely watching the markets for signs of
stability. The Euro has traded in a tight range over the past 48 hours.
Since only current account and industrial orders are due for release
tomorrow, the Euro could very well remain in a range. Meanwhile the
Swiss trade balance was also weaker than the prior month, but that has
not had much of an impact on the Swissie.

Canadian, Australian and New Zealand Dollars All Give Back Gains

The Canadian, Australian and New Zealand dollars all gave back their
gains today on the combination of weaker economic data and softer demand
for high yielding currencies. Even though Canadian consumer prices were
right in line with expectations, Canadian retail sales saw the sharpest
decline since September 2006. This was primarily due to a sharp fall in
auto sales and gasoline receipts. In comparison, sales excluding autos
fell 0.3 percent, which was right in line with expectations. Most
economists expect the Bank of Canada to leave interest rates unchanged
next month but some are still expecting a rate hike in October. As for
New Zealand, the annualized pace of growth in credit card spending also
slowed last month. This suggests that retail sales could continue to
remain soft.

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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