Dollar Collapses, Fed Fund Futures Show 90% Chance of Rate Cut by Year End
The problems in the US housing market are worsening and anyone who is long stocks, carry trades or the US dollar is feeling the pain. Next to the 3.2 percent decline in the Dow back in February, this is the largest one day point loss since the beginning of the year. Unlike the previous corrections that we had in June, there were plenty of clues that this one could be a lot worse. In yesterday’s Daily Fundamentals we talked about how even though the stock market recovered, yields were lower, which suggests that there may be more bad news to come. On Tuesday, we warned that risk aversion is returning, which meant that the sell-off in the yen crosses may be closer to liquidation than the profit taking that we have seen in the past. We were watching the Chicago Board Options Exchange Volatility Index or the VIX. At the time it was nearing February levels and today, it hit a new 13 month high. High VIX readings represent a rise in risk aversion and typically coincides with a sharp sell-off in US stocks. We can also tell that risk aversion has returned because credit spreads have widened significantly. The latest wave of panic selling has been caused by the combination of weak US economic data and news that Wells Fargo, the nation’s second largest home lender and fifth largest bank will stop making sub prime loans through third party brokers. We are clearly seeing the problems in the housing market extend beyond subprime. New home sales dropped 6.6 percent in the month of June while rising inventories drove the median price down 2.2 percent. Durable goods sales also fell short of expectation as defense spending slowed. The labor market may even be affected with newspaper help-wanted ads dipping to a 49 year low last month. The fact that jobless claims remains at healthy levels indicates that companies are not firing, but at the same time, it does not mean that they are hiring. In light of all of this weak data, Fed fund futures are now pricing in a 90 percent chance of a rate cut by the end of the year; this represents a sharp jump from the 44 percent chance reported yesterday. Given all of the disappointments reported today, there is a decent chance that tomorrow’s second quarter GDP growth figure will miss expectations. Even though the stock market has rebounded, yields are still sharply lower which suggests that dollar weakness may not be over.

Dow Plummets 300 Points, Carry Trade Liquidation Continues
Rising risk aversion has caused a wave of carry trade liquidation. None of the Yen crosses were spared in the second worst day for carry traders this year. The biggest losers were NZD/JPY and AUD/JPY, which dropped 400 and 340 points respectively. Carry trades only work in a market that is willing to take on risk. With evidence that things could get worse before they get better in the US, it may be wise for carry traders to stand aside for the time being. Some economists are once again calling for a recession. Market expectations have shifted dramatically which makes it a far more unstable environment than a few months ago. Tonight’s Japanese data is not likely to matter at this point because the problems are far more severe than the risk of a rate hike by Japan. Consumer prices and retail sales are due for release. Inflation is expected to remain nonexistent while retail sales are predicted to rebound. A rebound in the Yen crosses will however be contingent upon whether we see any follow through selling in the US stock market.

Commodity Currencies Suffer as High Yielders Go Out of Favor
As victims of carry trade liquidation, the Australian, New Zealand and Canadian dollars also sold off aggressively today. Unsurprisingly, the biggest mover was the New Zealand dollar which suffered greatly from last night’s dovish comments by Reserve Bank of New Zealand Governor Bollard. The trade balance is due for release tonight. The strong kiwi is expected to turn the surplus into a deficit, which could exacerbate the currency’s weakness. The New Zealand dollar should also begin to under perform its Australian counterpart as the recent inflation data from Australia has the market pricing in another rate hike this year. A turn is in place for all three currency pairs. We continue to expect more weakness in the Canadian dollar, particularly against the Japanese Yen.

Euro Rebounds on Broad Dollar Weakness; Swiss KoF Expected to be Strong
On a day with big moves in all of the financial markets, the EUR/USD was left out of the action. The meager 0.14 percent or 20 pip rally in the currency pair suggests that even though traders are bearish dollars, they are not all that bullish Euros either. Business sentiment in Germany is deteriorating with the IFO survey dropping from 107 to 106.4 in July. This past week, we have seen plenty of evidence that the strong Euro is having a negative impact on the Eurozone economy. However for the time being, the “negative impact” has not become severe enough to keep ECB members from enjoying their month long holidays. The rise in money supply indicates that inflation is still a problem, which means that the central bank can use a strong Euro to reduce inflationary pressures. Meanwhile Switzerland will be releasing its leading indicators report tomorrow. The economy has performed well over the past month thanks to the weakness of the Swiss franc. We expect the release to continue to reflect the country’s solid growth prospects.

Weak Housing Numbers Weight on British Pound
The British pound sold off for the second day in a row on the back of weak housing market data. Nationwide house prices increased only 0.1 percent in the month of July, dragging the annualized pace of price growth down to 9.9 percent from 11.1 percent. The Chief Economist at Nationwide blames the increase in house prices, but even so, traders should not lose sight of the fact that the UK economy is out performing the US economy. What is really weighing on the pound is GBP/JPY liquidation. When that comes to an end, so could GBP selling.

Kathy Lien is the Chief Currency Strategist at FXCM.