Dow Jones Falls 241 points, Dollar Rallies against Commodity Currencies

The U.S. dollar had a mixed performance on Monday during a trading session with very low liquidity since London financial markets were closed for a public holiday. The greenback was particularly strong against commodity currencies like the New Zealand dollar but continued to lose ground against low yielding currencies like the Japanese yen. Indeed, the New Zealand dollar fell to as low as $0.7036 from $0.7091 on Friday in New York and the USD/JPY was quoted at 109.33 yen on Monday from 109.85 on Friday. To some extent, the U.S. dollar recovered from earlier losses after a surprisingly strong report on home sales. According to the National Association of Realtors sales of existing homes in the U.S. rose by 3.1 percent in July, the highest level in more than six months. Yet, today’s headlines were dominated by the U.S. stock market which fell sharply on Monday on renewed concerns over the health of several financial firms. For instance, shares of Lehman Brothers fell nearly 6 percent on Monday after Jun Kwang Woo, a top South Korean regulator, expressed concern about Korea Development Bank's interest in buying the investment bank.

Tomorrow, we will have the release of the minutes from the last Federal Open Market Committee meeting, new home sales for July and the Conference Board consumer confidence index for August. Consumer confidence is expected to remain close to a 16-year low as Americans continue to worry about job security and falling property values. Looking ahead and despite the recent wave of profit taking, we expect dollar strength to continue. In fact, a significant U.S. dollar undervaluation is now likely to lead to a substantial improvement of the U.S. Balance of Payments through continued strong export performance. Moreover, a significant shift of interest rate expectations in favor of rate hikes by the Federal Reserve is likely to help the U.S. dollar to rally further.

Pound Volatility Leveraged By Low Liquidity

Though most of the UK financial sector was closed for Monday’s Summer Bank Holiday, the British pound was more volatile than it has been in some time. In fact, the GBP/USD pair was one of the most active for the session with a sharp, 90-point drop in the early Asian session that cleanly sheared 1.85 support and in turned triggered a substantial cluster of stops. The move clearly caught many speculative traders off guard, and encouraged a considerable number of retail participants to flip their positions just before the rebound. All of this was reflected in the DailyFX Speculative Sentiment Index which dropped from a 2.10 reading to 1.14 as long positions slipped 24 percent and shorts jumped 40 percent. So, where do we go after such a dramatic day? The UK economic docket is relatively light for Tuesday with only the BBA home loans figures for July due. However, considering the fundamental weight both housing and lending trends have over the long-term health of the economy and currency, this data may be sufficient for a good short-term reaction.

ECB Withdrawing Support For Banks While Fed Boosts Its Aid

The euro was mixed against its most liquid counterparts Monday as a lack of tangible event risk left traders to the range bound and congestive price action that has prevailed in EUR/USD over the past two weeks. However, the lack of day trading opportunities shouldn’t preclude the market’s interest in the day’s fundamentals. While the economic calendar was clear, comments from ECB council member Yves Mersch have put the spot light back on the central bank. In an interview on Saturday, the central banker said the group was concerned about banks taking advantage of lending efforts to help ease the burden of the credit crunch by dumping their illiquid and depressed securities on the ECB in order to clear their balance sheets. Mersch went on to say the group has already agreed on a number of changes to the existing rules to prevent inappropriate use of the aid going forward. Does this show a renewed sensitivity to the financial side to the monetary policy puzzle that the Fed has often focused on? Time and further rhetoric will tell. Looking ahead to the next 12 hours, event risk traders will need to be on guard. The final reading on third quarter, German GDP numbers may generate little enthusiasm (as there is rarely a significant revision over the previous measurements); but the IFO business and GfK consumer confidence surveys are more timely and therefore volatility worthy. It will be interesting to see how much leverage the drop in crude prices have over both group’s overall attitude on the economic outlook.

Drop In Stocks And Commodities Keeps Commodity Currencies Under Wraps

There was little activity in the commodity bloc Monday morning as the usually quiet entry to the week was exacerbated by the disappointing performances on the group’s two complementary drivers: commodities and the demand for high yielding assets. Acting as a counterbalance to the modest US dollar selling permeating the market, crude prices were relatively unchanged through Monday’s session at $115.21/barrel while gold slipped 0.9 percent to $819.80 through the US pit close. More influential for the high-yielding Aussie and kiwi dollars specifically was the 2 percent-plus drop in US stocks and complementary rise in risk gauges. When the threat of volatility rises while demand for return decreases, the interest rate intensive commodity currencies are usually the first to be liquidated.

Yen Rises As Risk Carry Interest Diminishes

Bank of Japan Governor Masaaki Shirakawa roused little interest among rate watchers with a speech on monetary policy early this morning. Comments made by the central banker suggested he would keep lending rates at current lows for the foreseeable future as they would help the economy avoid a “deep” economic slump. For the market, there is little to no chance the BoJ would hike given current economic conditions (and any modest hikes at these levels would do little to unsettle the carry trade anyway); so instead traders showed more interest in the relatively comforting growth outlook in Shirakawa’s comments. The real strength for the yen however, was borne out of the sharp pull back in equities and other high-return, high-risk securities. The Dow 30 dropped more than 2 percent while the S&P VIX jumped up to 21 percent from a two and a half month low on renewed concern over the health of the financial sector as another (small) US bank succumbed to the credit crunch.

Terri Belkas is a Currency Strategist at FXCM.