Carry Trades: Are They in for More Losses?
With the US bond markets closed for Veterans’ Day, the equity and currency markets were as volatile as ever. Intraday charts show US equities fluctuating in and out of positive territory with the intraday trading range of the Dow reaching as much as 181 points. The Japanese yen crosses were in the red or negative throughout the US trading session. Today’s extensions of Friday’s losses were not a complete surprise because on Friday we had indicated that with the Dow closing “at its session lows, we expect follow through weakness in the yen crosses at the open of Tokyo trading on Sunday.” What we didn’t expect however was the degree of the move, which in some cases matched and surpassed that of the moves we saw on Friday. The combination of stronger Japanese economic data and significant weakness in the Asian stock markets appeared to be too much for carry traders to bear. Domestic CGPI and the current account were both better than expected, but stronger economic data alone would not have caused today’s move. The Chicago Board Options Exchange Volatility Index (VIX) opened at the highest level since August, when we had a big spike up to 37.50. Carry trades thrive in an environment of low volatility which means that should the VIX continue to rise, and it appears to want to, carry trades could suffer more losses. It is important for yen traders to not only watch the Dow, but also the VIX. Tonight, we have the Japanese GDP report for the third quarter, which is expected to be firm.

US Dollar Expected to Rebound this Week
Despite the lack of any US economic data released today, it is already shaping up to be a dollar-positive week. Oil prices are lower and gold plummeted as much as $30 an ounce. The main events this week are producer prices, retail sales and consumer prices. Bernanke is also holding a special session on November 14 to announce changes in FOMC communications but this should not be market-moving since he is only expected to announce measures to increase the transparency of interest rate decisions such as giving more forecasts and extending their horizon. We continue to believe that the data this week has a greater chance of surprising to the upside. The estimates for October retail sales are low (0.2 percent) because many of the nation’s largest retailers have missed their sales forecasts. However, non-farm payrolls over the past few months have been exceptionally strong and gasoline prices in the month of October remained steady, which means that retail sales could still beat expectations. Also, we expect both producer and consumer prices to surprise to the upside given the rise in food and energy prices. Will this be THE bottom in the US dollar? No. The reason why the Dow and carry trades were so weak today is because the market is still concerned that a large structured investment vehicle has blown up and Deutsche Bank’s predictions of another $400 billion in subprime losses could materialize, which of course is not good news for the US economy.

Canadian Dollar Sees Biggest One Day Slide in 36 Years
The Commodity Currencies are all significantly weaker against the US dollar today as a result of carry trade liquidation and commodity price retracement. Economic data is not really to blame because even though New Zealand house prices grew at a slower annualized pace last month, the RBA statement was more hawkish than dovish. The RBA revised down their growth forecasts for the next 2 years but they also revised up their inflation forecasts. Canada did not release any economic data, but the currency still managed to incur its biggest one day slide in three decades. On Friday, we had said that fundamentals, technicals and sentiment all pointed to a reversal but we did not expect the majority of the move to happen in one day. Although we could see further gains, parity will be an exceptionally hard level to break in USD/CAD. Australian business confidence is the only piece of data due for release from any these three countries over the next 24 hours. With the Dow closing at its session lows, there could be further losses.

Euro: Be Careful of What You Buy
Depending on which currency pairs you traded today, you could have made money being long Euros. On Friday, we had said that the better buy this week may be relative strength plays like EUR/GBP or EUR/CAD than the EUR/USD itself because of the risk of stronger US data. Interestingly enough EUR/GBP and EUR/CAD were two of the few currency pairs that are actually up on the day. In an environment where we have a potential for a dollar rally, the dollar’s biggest gains would be against the currency pairs whose rise have been driven mostly by speculation and flow rather than economic data. This is the case with the British pound which reported only downside surprises last week and the Canadian dollar, which has rallying on the belief that oil will reach $100 a barrel. Although this trend could continue, tomorrow we should have some Euro driven movements with German GDP, the ZEW survey and Industrial Production due for release.

British Pound: Down 400 Pips
Even though inflation in the UK rose by the fastest pace in 1 year, the British pound fell 400 pips today. Last week the British pound rallied 300 points despite signs of weaker growth and it is not until this week that price action finally reflects fundamentals. This is more obvious when we look at EUR/GBP. After range trading between 69 and 70 cents for the past 2 months, we finally see a strong break to the upside. The ECB and BoE face similar inflationary conditions but the ECB could realistically raise interest rates given stronger economic data while the BoE does not have much choice other than to keep rates unchanged for the foreseeable future.

Kathy Lien is the Chief Currency Strategist at FXCM.