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Why has the Dollar Strengthened as the Stock Market Falls?

Reports of more subprime related losses have sent the markets tumbling once again. The stock market is down another 100 points, putting this week’s losses in the Dow close to 500 points. Carry trades and other high yielding currencies have followed suit as more victims of the subprime fallout surface. Domestically, Sowood Capital Management, a hedge fund founded by a former Harvard Management executive suffered bond losses in excess of 10%. A Citigroup analyst also released estimates of the potential losses at Fannie Mae and Freddie Mac, whose bond holdings are estimated to have dropped by $4.7 billion. Internationally, Australian hedge fund Absolute Capital group suspended withdrawals from two of its funds as a direct result of subprime contagion. The problems have now gone global which means that the age of easy money is over. Investors and lenders in general will be far more careful about who and what they are willing to fund. Even if the markets do rebound, sentiment has shifted so dramatically that we probably won’t see 14,000 in the Dow or fresh highs in carry trades again this year. The most common question that we are being asked right now is why is the dollar rallying? The answer is because now that the global liquidation has deepened, investors are steered back into the US dollar because of its safe haven status. Many US investors have exposure abroad and when they cut their risky trades, they are also repatriating their funds back into US dollars. Only a recovery in risk appetite will save the markets at this point. Although the Dow could bounce given the strength of its recent moves and the fact that prices are nearing key levels of previous support, keep an eye on bond yields because if they continue to remain weak or sell-off, more losses in carry trades and equities is possible. Meanwhile, today’s data gives traders no reason to be optimistic. Even though GDP rose by a more than expected 3.4 percent in the second quarter, the drop in prices as well as slower personal consumption growth still give reason for concern. Looking ahead, next week is busier than ever. Not only do we have non-farm payrolls on Friday, but service and manufacturing sector ISM is due for release along with personal income and personal spending. Even if we get stronger outcomes, the market may still look for the Federal Reserve to cut interest rates at the end of the year.

Carry Trade Unwinding Continues, More Losses in Store
High yielding carry trades continued to perform horribly today with AUD/JPY and NZD/JPY falling another 300 points. The Chicago Board of Trade’s Volatility Index continued to rise and is less than a point shy of its 52 week high. Carry trades only perform well in low volatility environments. The fact that volatility shot up so much so rapidly makes carry trades or basically the desire for yield far less attractive for the risk. Even though USD/JPY and CAD/JPY are stronger, they have hardly put a dent into Thursday’s losses. Japanese data released overnight was mixed with consumer prices falling, but retail spending increasing on an annualized basis. The Nikkei was also down 418 points or 2.3 percent overnight. This seems to matter little for yen traders because they are solely focused on the market’s aversion for risk. If stocks continue to collapse, carry trades will continue to fall. Meanwhile in the week ahead, there is a lot of data on the Japanese calendar including industrial production, the trade balance, household spending, labor cash earnings, and the jobless rate. The market has gone from pricing in a 64 percent chance of an August rate hike to a 45 percent chance.

Uptrend in Commodity Currencies Come to an End
The trend of multi year highs in the commodity currencies have finally come to an end this week with the New Zealand, Australian and Canadian dollars suffering significant losses. The biggest losers in the currency market today were also the NZD and AUD. As warned by central bank Governor Bollard earlier this week, exporters are definitely beginning to feel the pain of a strong currency. Both imports and exports dropped significantly, turning the NZ trade surplus into a deficit. Meanwhile there have been reports that model and momentum funds are aggressively selling the Aussie which means that they are no longer holding out the hope for a recovery in the high yielders and are instead either getting stopped out or initiating fresh short positions. Australia has retail sales next week which will be worth watching. Canada on the other hand has raw material and industrial product prices along with GDP and IVEY PMI. USD/CAD has bottomed out and we expect the bottom to hold.

EUR/CHF Sees Biggest Weekly Drop in 4 Months, EUR/USD Weakens on Dollar Strength
Over the past 2 days, the Swiss franc has rallied significantly against the Euro as a direct result of the currency’s own safe haven status. The KoF report of leading indicators was stronger than expected which has also helped, but the move in the currency pair began on Thursday. In the week ahead, we have the UBS consumption indicator and PMI from Switzerland. Both are expected to remain strong, illustrating the overall health of the economy. The Euro on the other hand has weakened for no other reason than dollar strength. There are a ton of PMI, unemployment and consumer spending reports due out next week, which could lead to some Euro drive action.

Weak Housing Numbers Weight on British Pound
Like the Euro, the British pound has sold off significantly today on the back of liquidation of high yielding assets as well as a broad dollar recovery. House price growth continues to be soft which could be concerning going into next week’s heavy economic calendar. We are expecting more housing market reports as well as money supply, consumer confidence, distributive trades, manufacturing and service sector PMI. Overall the UK economy still remains healthy and the Bank of England could raise rates to 6 percent by the end of the year. The global markets just need to stabilize before these factors come into play once again.

US Dollar Drops to Fresh Lows on Pronounced Stock Market Tumbles

The Euro rallied to fresh record-highs against the US dollar, with sudden fallout in domestic equity markets sending the Greenback lower across the board. Disappointing earnings reports from internet titan Google Inc. and construction conglomerate Caterpillar Inc. led broader indices significantly lower. Such stock market tumbles were likewise enough to send 10-year Treasury yields crashing below 5.00 percent—adding further selling pressure to USD pairs.



The Euro saw peaks of $1.3842 before settling to trade at $1.3812 through time of writing. British Pound bulls likewise sent Cable to 26-year highs of $2.0568, while a modest pullback saw the Cross-Atlantic currency pair move to $2.0544. Further rallies were limited by a simultaneous advance in the Japanese Yen, which saw the USDJPY lose as many as 130 points off of daily highs.

There was no new economic data out of the US on the day. Yet markets experienced a significant jump in price movements across the board, as the S&P 500 Volatility Index (VIX) added a whopping 2.26 to weekly highs at 17.48 percent. The closely-monitored VIX serves as an accurate measure of overall risk aversion across financial asset classes, which likewise explains the sharp drop-off in the popular forex carry trade. In fact, a simple correlation study shows that the high-yielding Australian Dollar-Japanese Yen currency pair keeps a strong -0.55 correlation with the measure. Though equity performance hardly dictates every movement in the JPY, experience has clearly shown that stock market tumbles have had far-reaching effects on the incredibly oversold Japanese currency. It will subsequently be important to watch the performance of Asian markets through Sunday night’s open; extended declines would only further fuel the JPY short-covering.

The Dow Jones Industrial Average stole headlines for all the wrong reasons, losing a substantial 160 points to 13,840 through time of writing. Broader S&P 500 stocks fared no better, as the index shed 1.2 percent to 1,534.63. Yet declines in the Dow and S&P still fell short of the drop in the tech-heavy NASDAQ Composite, which moved 1.34 percent lower to 2,683.54. Earnings reports and renewed talk of Subprime lending fears were the primary culprits for the significant losses. Disappointment in Google Inc.’s Second Quarter numbers sent the high-flyer 5.0 percent worse to 521.00, while Caterpillar Inc. tumbled 7.75 percent to 80.24 for much the same reason. Likewise significant, an early speech by St. Louis Fed President William Poole reignited market jitters on the lending crisis. The official said that the subprime lending issues were pronounced enough to dampen outlook on the broader housing market. Though the speech was largely a restatement of what was already known, the text teamed up with disappointing earnings reports to send equities lower.

Fixed income markets saw significant rallies on a flight to quality, with the US 10-year Treasury Note up ½ points to 96 and 19/32. Yields took a hit on the day, breaking below the key 5.00 percent mark to trade at 4.94 percent at time of writing. Such rising bond prices and falling yields bode poorly for the potential of a US dollar retracement, with the greenback remaining relatively subdued despite signs of stabilization across markets.

China Central Bank Raises Interest Rates To Cool Overheating Economy

In response to the rapid pace of growth in the world’s fastest growing economy, the People’s Bank of China raised interest rates by 27 basis points. Bringing the benchmark lending rate to an eight year high of 6.84 percent, policy makers additionally increased the deposit rate to 3.33 while cutting the tax on interest income, hoping to promote savings. The tax rate will incidentally drop to 5 percent from 20 percent beginning August 15th. Already expected by the market, the decision will, however, likely do nothing in denting the current pace of economic growth as money continues to pour into China, especially the stock market. For the year, with speculation on the bid side running rampant, the benchmark index has risen 95 percent after more than doubling returns in the previous year. Subsequently, the gains have supported higher consumer and business spending, driving economic growth to the fastest in 12 years. Ultimately, the market should expect further tightening measures (if they are to come) in the near term with the proposal of a more flexible currency regime still on the back burner. With the decision widely digested by the equity markets already, the currency was taken back a bit in the overnight session, falling to 7.5740 against the US dollar as well as the Euro and the British pound. Incidentally, there was some speculation that had surfaced over a potential intervention by the PBoC, helping the Chinese yuan to drop in dramatic fashion.