By DailyFX – On Friday just before the opening US stock market trading the Fed announced a 50 basis point… … cut in the discount rate.

The discount rate
is the rate Fed charges to other banks and is nearly always higher than
the far better known Fed funds rate which is the rate banks charge each
other for overnight loans. In reality the move was more symbolic than
meaningful. The discount rate accounts for a miniscule amount of loan
business. For example discount lending averaged just $11 million in the
week ended Aug. 15 paling in comparison with billions of dollars that
the Fed injected into banking system through its open market operations.
Nevertheless, stocks bounced on a much needed relief rally with Dow
ending above the 13K for the week.

The move produced a change in the trend that dominated the currency
market the whole week. As we wrote on Thursday, The dollar now finds
itself in a bifurcated market weaker against the yen but stronger
against all other G-10 currencies. It has become the primary beneficiary
of the carry trade unwind as currency traders sell the high yielders
and park their assets in dollars for the time being.” By Friday however
those trades began to reverse as EURUSD rallied by more than 100 points
from its weekly lows as risk appetite returned.

Does the discount rate cut presage a cut in the Fed funds rate? All
signs point that way especially if US economic growth slows
significantly in the next several weeks. Ironically enough, past weeks
data on the Trade Balance should result in an upward revision on GDP
growth putting further distance between US and EZ Q2 GDP figures. But
the markets are unlikely to pay much attention to past performance. Far
more significant will be the Durable Goods data due on Friday. If US
consumers are indeed starting to retrench the long term impact on the
dollar is likely to be negative as traders will begin to price in the
risk of recession. -BS

Euro At the Whim of EURJPY

The flows in EURUSD this week were driven almost exclusively by the
price action in EURJPY which has become the proxy for risk appetite in
financial markets. As risk aversion took hold EURJPY plummeted taking
euro down with it and as the fear eased EURUSD rallied. For the week the
pair saw a rather wide 350 point range but it was tame in comparison to
the more than 1200 point range in EURJPY. As the week came to a close
the sharp declines in EURJPY no longer precipitated very strong sell-off
in the EURUSD. The unit was still vulnerable to carry trade liquidation
factors but as the price declined it found more and more bids as
traders perceived value at those levels.

On the economic front the news was unsupportive of the euro. EZ GDP
missed expectations, printing at 2.6% vs. 2.8% forecast. As we noted on
Tuesday this is the first time since Q1 of 2006 that EZ GDP has been
weaker than US GDP. While one quarter does not make a trend, this
dynamic bears careful watching. The rally in the EURUSD over the past
year has coincided with the outperformance of the region’s GDP versus
that of the US. If that dynamic has now changed and EZ GDP will begin to
lag US GDP growth the euro could weaken further as we the second half of
the year progresses.

Next week the market will get a look at the Industrial Production
report as well as both Manufacturing and Services PMI. If the data shows
further deterioration in the region the case for an ECB rate hike in
September will grow weaker and weaker. Although the ECB prides itself on
consistency and transparency it may have to hold off any plans at
tightening given the turmoil in the markets and the surprising
deceleration of growth. BS

Japanese Yen Remains Reliant On Risk Aversion

The Japanese Yen proved to be unstoppable last week, as a lingering
liquidity crunch drove equity markets lower and led carry trades to
unwind further. In fact, the oft-beleaguered, low-yielding currency
jumped 3.8 percent against the US dollar, more than 5 percent against
both the Euro and British pound, and a whopping 11.2 percent against the
New Zealand dollar. This dramatic price action only highlights the fact
that Japanese fundamentals are playing absolutely no role whatsoever
into buying and selling of the yen. Case in point: GDP slowed
dramatically in the second quarter, easing to a tepid 0.1 percent pace
from the first quarter, while the annualized rate plummeted to 0.5
percent from a downwardly revised 3.2 percent. A breakdown of the data
shows that capital investment in the private sector expanded, but
consumption was down and exports failed to grow as US demand fell,
curbing the Japanese economy's growth. It appears that when the US
sneezes, much of the world still catches the flu, and given the
deteriorating economic conditions we’ve seen develop over the past week,
the prognosis may get worse in Japan.

As it stands, there are really only two fundamental events that could
perpetuate a strong move by the Japanese yen: a rate hike by the Bank of
Japan or a jump in inflation neither of which we’ll see this week. The
central bank is scheduled to meet and announce their rate decision on
August 22nd, and while there is no specific time available, it tends to
be released around 23:50 EST. Globally, rate hike speculation has been
curbed dramatically, and Japan is no exception. Despite the fact that
fixed income markets had previously been pricing in a rate increase by
the Bank of Japan, we saw little economic support for a return to rate
normalization given softness in consumption growth and continued
deflationary conditions. As we mentioned above, economic conditions in
the US and Japan appear to be worsening, which severely limits the
ability of the central bank to take any monetary policy tightening
measures. As a result, USD/JPY will remain at the whim of carry trade
flows, so traders should remain alert to the risk aversion trends that
have recently contributed to weakness in the pair. TB

British Pound Hammered By Risk Flows, Data And Rate Outlook

Though the pound sterlings loses last week were far from those
recorded by the Australian and New Zealand dollars, they may have been
fatal to the currencies long-term bullish trend. For once, the market
had an overabundance of reason for the pounds drop. Looking first to
the tidy economic calendar, there were a number of indicators
contributing to the recent, aggressive price action. There were two
arteries of fundamental data through the pair: inflation and the
consumer. Each had promising components, but both were ultimately
detrimental to the pound. For the consumer sector, retail sales were the
silver lining. A 0.7 percent increase through the month of July far
outpaced expectations and marked a five month high. Whats more, a
modest drop in jobless claim benefits helped push the claimant rate to a
more than two year low. However, a plateau in both spending and hiring
may have been signaled by a big turn in wage growth. Average earnings
grew 3.3 percent through June, the slowest pace since June 2003. The
inflation data had fewer bright spots. Consumer inflation dropped the
most in five years in July as a 1.9 percent print for the headline read
slipped below the BoEs target rate. The core figure followed suit in a
big drop from 2.0 percent to 1.7 percent. The inflation data will be
integral going forward as it gives the central bank a solid foundation
to respond to the recent credit and liquidity woes in Londons capital
market. Even before this data was fully absorbed, the minutes from the
central banks August monetary policy gathering had already revealed a
9-0 vote against further hikes with comments that were sounding
increasingly like those that would be made by doves.

Looking at the week ahead, the true risks to direction and volatility
will likely not be easily divined. The economic calendar will struggle
to play a major role in price action. After last weeks spending,
employment, wage and inflation data, there are few market movers left in
the fundamental confers. However, considering current market conditions,
a few low key indicators may actually have outsized effects on the pound
this time around. As speculators calculate the probabilities of if/when
the central bank will genuinely entertain a possible rate cut, the
Rightmove housing price index and the M4 money supply numbers will give
objective numbers to work with. The final reading on second quarter GDP
is forecasted to pass its mark unchanged, but a revision could generate
considerable buzz. A downgrade would add to concerns that have already
been raised through the drop in earnings and inflation. On the other
hand, a pickup like the one expected for the US growth report could
dampen irrational fears that the pound is falling apart. However, when
everything is said and done, the true fuel for price action will likely
remain the global flight to quality and fears that US credit problems
will fully entrench themselves in the UK. JK

Will The Carry Trade Unwind Work Against Swissie?

As a low-yielding currency, we previously saw price action in the Swiss
franc follow the Japanese yen. However, the correlation diverged last
week as USD/CHF rose 0.65 percent while USD/JPY fell 3.81 percent, as US
dollar strength against everything but the Japanese yen dominated the
forex markets. Looking at the crosses, Swissie fared a bit better
gaining 0.94 percent against the Euro and 1.46 percent against the
British pound. Economic data out of Switzerland did not help the case of
the Swiss franc either, as retail sales slowed dramatically to an
annualized rate of 1.0 percent from 7.2 percent. The drop is someone
disconcerting, as resilient consumption growth has led to goldilocks
economic conditions in Switzerland. Furthermore, this follows a similar
drop in the SECO consumer climate report, and it appears that consumers
are starting to feel somewhat jittery as concerns build that a slowdown
in the US will spread into other regions. Nevertheless, with the
unemployment rate at a nearly five-year low, Switzerland is unlikely to
see a sharp decline in domestic spending in the near-term.

Economic data out of Switzerland tends to be thin, and this week is no
exception. First, producer and import price growth is expected to pick
up 0.3 percent, however, the datas impact on the Swiss franc may be
limited as inflation remains very tame. Furthermore, given the
instability of the financial markets, most central banks including the
Swiss National Bank are no longer anticipated to raise rates. As a
result, USD/CHF trade will likely remain dependent upon price action for
the greenback, and with risk aversion still the main theme for the forex
markets, the pair may target 1.2200 once again. TB

Canadian Dollar Loses Traction on Carry Shakeout

The Canadian dollar finished lower for the first week in four, as a
sharp carry trade unwind sent the currency significantly worse against
the Japanese Yen. The CADJPY posted its worst single-week decline in
nearly a decade before a later carry trade bounce eased losses. A
simultaneous flight to safety to its US namesake pushed the USDCAD to
fresh two-month highs, leaving momentum clearly to the upside through
short term trade. Domestic economic data only further fueled Loonie
drops, with International Trade and Securities Transactions coming in
below consensus forecasts. Domestic Manufacturing likewise showed signs
of continued skids; Shipments lost a whopping 1.8 percent through the
month of July. As the most trade-dependent country of the G-8, Canadas
economic growth will sorely depend on a rebound in key trade figures.
Such dismal performances have subsequently dimmed prospects on GDP
expansion rates, and with them forecasts of higher Canadian interest
rates through year end. In fact, the Loonie yield curve has now priced
in an approximate 50 percent chance of a rate cut by December. Such
developments certainly leave a bearish tone on Canadian dollar trade,
but the upcoming week of inflation data may force markets to reassess
forecasts on domestic yields.

Tuesdays Consumer Price Index and Retail Sales reports may potentially
shift expectations for Canadian interest rates and subsequently force
large moves in the domestic currency. The Bank of Canada Core Consumer
Price Index rate is forecast to come in at 2.3 percent on a
year-over-year basis, above BoC targets of 2 percent but down from
Junes 2.5 percent result. Such signs of moderating price pressures
will easily be enough to keep a lid on rate hike expectations, leaving
the Loonie to falter against its US namesake. It will conversely take a
strongly positive surprise to lift market yields above an astonishingly
low 4.27 percent on the December contract. A later Retail Sales Report
is likewise unlikely to spark a jump in yields, with a disappointment in
recent Wholesale Sales figures predicting the same through Tuesdays
report. Consensus forecasts call for a 0.5 percent drop through July,
but retail turnover may drop further following a 2.8 percent surge in
June. This will do little to help the Loonies cause, leaving risks to
the downside for the currency through the coming week of trade. – DR

Australian Dollar Plummets, RBA Puts Reserves Into Action

The Australian dollar was one of the top movers this past week.
Unfortunately, for those that were trying to catch a bottom, the pain
probably seemed endless since AUDUSD traced out its biggest weekly drop
since 1983. Realistically, the economic calendar had little hand in all
the price action, though there were a number of releases that could
shape growth trends and the RBAs policy outlook in the months ahead.
Inflation projections received a boost from a the quarterly wage growth
report. Earnings ramped up to its fastest pace of growth since the first
quarter of 2005 in the second quarter. Another strut for the economy
came from the NAB business sentiment survey through July. Australian
firms reported record profits and sales for the month that in turn
lifted the current conditions report to its highest level in the
indicators short 10-year history. However, even this indicator had its
downside as the outlook turned decidedly sour with concerns raised over
the effect of higher interest rates on profit. Consumers were worried
about the same thing. The biggest drop in optimism in nine months was
clearly a sign of discomfort with lending rates an 11-year high and
massive losses to investment portfolios as the equity market plunges.

Though the aforementioned indicators were fundamentally important to
the Australian economy and currency, the real impetus for price action
was found elsewhere namely global credit and equity markets.
Initially, policy officials the world over repeatedly reassured the
markets that the growing subprime issue in the US would be contained to
its boarders. However, after a number of international banks and hedge
funds reported problems (including Australias own Macquarie and Basis
Capital), fear swept the globe like wild fire. For Australia, the panic
was reflected in the Australian dollar, bonds and equities. The nation’s
benchmark S&P/ASX 200 closed last week down 12 percent from highs set
just a few weeks ago. Through all of this, the central bank tried more
than once to pull the Aussie dollar out of its nosedive. Following up on
previous weeks rate hike, Governor Glenn Stevens released a quarterly
monetary policy report that dripped with hawkish rhetoric. Key from the
report was the upgrade in inflation expectations such that a hike seemed
almost inevitable by early next year. Despite the report though, and
Stevens active echo at his Parliamentary testimony later in the week,
the Aussie dollar didnt respond. When all else failed, the governor
decided to use the central banks reserves to prop the currency; yet
even that failed to charge bulls.

In the days ahead, exogenous factors will likely steer the Australian
dollar once again as there is no top tier indicators scheduled for
release. Should risk aversion continue to drive down the currency,
Governor Stevens will likely try to encourage the market through verbal
reassurances and perhaps another round of intervention. However, the
RBAs reserves are relatively small and their efforts may ultimately
have the same lack of effect that the RBNZs did a few weeks ago.
Another problem may grow out of Chinas markets. With investors pulling
capital out of emerging markets, the giants engine of growth may
stutter and demand for Australias raw materials in turn will cool. —
JK

Carry Trade Decimates the Kiwi, Can it Come Back?

The New Zealand dollar posted incredible losses against major trading
counterparts, with a well-publicized carry trade rout dooming the
currency to continued tumbles. The now-infamous strategy recently saw
its second-largest drawdown since the inception of the Euro. A portfolio
that remained long the three highest-yielding major currencies and short
the 3 lowest-yielders lost an unleveraged 10.3 percent from late July
highs. This is second only to the 10.8 percent drawdown seen in 2006,
but the severity of the most recent occurrence underlines the level of
fear across financial asset classes. Whether or not carry can make a
comeback remains the critical question in outlook for the Kiwi, as
recent economic data has likewise left a bearish tone on price action.
Retail sales disappointed strongly to the downside, signaling that
fast-growing consumption in the small Asia-Pacific may slow from its
previously impressive pace. This in and of itself would give signs to
the Reserve Bank of New Zealand that its monetary policy tightening has
begun to take effect. Given that the kiwi has primarily found strength
on expectations of further interest rate hikes, lower consumption and
inflation rates would only add further downward pressure on NZD pairs.

Upcoming event risk will be relatively sparse in the New Zealand
economy, but Thursdays Trade balance report threatens volatility on any
surprises in the data. Though there is yet to be an official consensus
forecast for the report, it remains safe to say that analysts expect new
Zealand trade deficit to remain relatively unchanged. An exceedingly
high exchange rate hurts the competitiveness of Kiwi exports abroad,
while strong domestic consumption has made imports surge to
record-highs. The recent tumble in the domestic currency will only
exacerbate such trends through the short term, but may lead to a
longer-term improvements in net exports for the Kiwi economy. Markets
speculate that the impending surge in import prices may force the
Reserve Bank of New Zealand to raise interest rates to contain
inflationary pressures. This could potentially lend a bid to the
downtrodden NZD currency pairs, but such an outlook will greatly depend
on the performance of the global carry trade through the same period.
Given such an extended carry unwind through recent weeks, it may be only
a matter of time before we see the strategy slowly regain ground.
DR

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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