Carry Trades: Headed for More Losses?
The Dow plummeted 238 points today, triggering a major turn in carry trades. For carry trades to thrive, central banks need to be raising interest rates, volatility needs to be low, traders need to be optimistic and risk appetite needs to be strong. Unfortunately, this does not describe today’s market environment. Over the past few months, many of the major central banks have lowered interest rates for the first time in years. The world is embarking on a major easing cycle which will contrast sharply with the global tightening cycle that lasted from 2004 to 2006. Volatility has also rebounded from its record lows while risk appetite has plunged. Part of the reason why carry trades continued to weaken is because traders expect global growth to slow even further. As the US flirts with recessionary conditions, the chance that the Federal Reserve will ease interest rates by 100bp is continuing to rise. At best for carry bulls, the Fed will ease by 50bp this year. At worst, they will ease by 125bp. Either way more easing is a necessity and this dynamic will make it difficult for carry trades to rally. The Dow broke a significant support level when it closed near its intraday low. It is realistic to expect at least another 100 point in losses which would take the index to its August lows. If the Dow to continues to sell-off, we will see further weakness in carry trades.

More Reason To Be Worried about the US Dollar
After a brief recovery, dollar weakness continued as incoming economic data gave the market more reason to be cautious about the outlook for the US economy. Pending home sales fell 2.6 percent in the month of November which suggests that difficult times lie ahead for the housing market. With the exception of the South, contracts to buy previously owned homes dropped across the country. Tack on a sharp rise in consumer borrowing to pay for holiday purchases and there is good reason to believe that the US economy will continue to suffer. Retail sales are the key because steady consumer spending will give the Federal Reserve the flexibility to ease rates by only 25bp. If consumer spending buckles, the central bank will have no choice but to bow to market pressures and ease more aggressively by cutting interest rates 50bp. According to the comments by Fed Presidents Plosser and Rosengren, inflation remains a concern but the outlook for the US economy depends on housing. If the downturn escalates, expect widespread ripple effects.

Euro: No Major Moves until ECB Meeting
Despite volatility across the financial markets, the Euro ended the day virtually unchanged against the US dollar. Economic data was mixed with retail sales dropping 1.4 percent compared to a year ago, which is the sharpest decline in 11 years. This Euro bearish release was offset by German factory orders which increased strongly in the month of November. Foreign demand has remained steady but domestic demand was the primary catalyst for the jump in manufacturing orders. This is a reflection of the overall health of the German economy and part of the reason why the European Central bank will remain hawkish at their monetary policy meeting on Thursday. Before that, we are expecting the German trade balance, current account, retail sales and industrial production numbers tomorrow. Most of these numbers are expected to be strong, but the drop in Eurozone retail sales makes us cautious about the strength of German retail sales. We still expect the EUR/USD to continue to strengthen in the medium term as the stark divergences in monetary policy, labor market stability and economic outlook for the Eurozone and the US make the single currency a far more attractive investment opportunity.

Rebound in British Pound Unconvincing
The rebound in the British pound today is unconvincing since the currency failed to hold onto its intraday gains against the US dollar. According to HBOS PLC, house prices increased unexpectedly in the month of December. Although it may be tempting to call this a recovery, it most likely represents nothing more than a corrective bounce within an overall downtrend. Also, the BRC retail sales monitor reported the weakest sales growth in 21 months. Over the next 24 hours, we are expecting the BRC shop price index and leading indicators. For the time being, there is no reason to buy the British pound. The market is still pricing in a 40 percent probability for a 25bp rate cut on Thursday. Even though we do not expect the central bank to lower interest rates, leaving them unchanged may be enough to trigger a short term bounce in the British pound since those traders who have positioned for a rate cut would need to adjust their exposure accordingly.

Australian Dollar Rallies on Record Gold Prices and Strong Economic Data
The Australian dollar rallied strongly today thanks to solid economic data and record high in gold prices. In the month of December, Australia reported the strongest construction activity in nearly 2 years. This says a lot given that the Reserve Bank of Australia raised interest rates twice in 2007. The market was originally looking for building approvals to remain unchanged, but instead, they increased by 8.9 percent in the month of November. Tonight we are expecting Australian retail sales. The health of the labor market in November and strength of the housing market suggests firm consumer spending, which should lead to further appreciation in the Australian dollar. The New Zealand and Canadian dollars on the other hand had no economic data to offset the liquidation out of high yielding currencies. The Canadian dollar suffered the most despite a rise in oil prices because BoC Deputy Governor Kennedy warned that downside are growing.

Kathy Lien is the Chief Currency Strategist at FXCM.