Blame Dollar Weakness on the Fed, Bush and China
Volatility continues to rule the financial markets with the Dow rallying, retracing and then rallying once again. The yen crosses followed suit but the pullbacks were less severe. This type of volatility in the markets represents significant two-way action and a great deal of uncertainty on behalf of traders and investors. The biggest news in the financial markets today was China’s threat to dump US Treasuries and US dollars. Both the US dollar and bond prices have sold off drastically on the news even though we expect this to be nothing more than empty threats since China and the US are interdependent. Treasury Secretary Paulson made a special appearance on CNBC to refute fears that China has the power to rattle the US markets. President Bush did the same on Fox News, indicating either how serious the government is taking the potential threat or their concern about the stability of the financial markets. This caused the reversal of stock market gains, but stocks regained their momentum after Bush reassured the markets that the US economy can deal with market volatility and therefore they did not feel that Fannie Mae needed to be bailed out at this point. The dollar is stronger today against the Japanese Yen, but weaker against every other major currency. In fact, the dollar is slipping back towards its record lows against the Euro. Part of the reason for the dollar’s weakness today was due to China’s announcement, but the other contributing factor is the commitment by other central banks to continue raising interest rates. This morning, hawkish comments by Bank of England Governor King pretty much guaranteed 6 percent rates by the end of the year. The Reserve Bank of Australia raised interest rates last night and left the possibility of another hike by Christmas. Last week the ECB held a special press conference just to tell the world that despite the recent fluctuation in the markets, they still plan on raising rates next month. In contrast, in the US, it is not just a matter of if, but a matter of when the Federal Reserve will announce its plans to cut interest rates. The clear divergence between what the Fed and every other central bank is doing is a big reason why the dollar not only weakened today, but could continue to weaken in the days to come. Meanwhile there was good news on the data front. Wholesale inventories, wholesale sales and mortgage applications all increased more than expected. The big rise in wholesale sales suggests that we could see an upward revision to second quarter GDP.

Are Carry Trades Back?
Carry trades continued to track the US stock market tick for tick. Today, impressive rallies were seen in all of the Yen crosses, raising the question of whether carry trading is back. Although it may be tempting to say that it is because we could see a bit more strength in pairs like AUD/JPY, USD/JPY and GBP/JPY, the market environment has changed significantly over the past few weeks. The age of easy money is over with many leveraged buyout deals and plans for stock buybacks cancelled. These were the primary drivers of equity market strength in the first half of the year and their disappearance will make it much more difficult for the Dow to return to its record highs. If the Dow fails to rally back towards its prior highs, then carry trades will probably not see new multiyear highs either. Furthermore, carry trades thrive in low volatility environments and the recent intraday moves in US stocks is anything but low volatility. With harsh lessons learned over the past few weeks, speculators will be far more cautious about assuming risk in the months to come. Standard and Poor’s warned today that they may cut ratings for more than $900 million Alt-A bonds, which means that now is not the time to become complacent. Although Japanese economic data continues to be weak, it will have a more of a secondary impact on the Yen crosses.

British Pound Rallies in Anticipation of 6 Percent Interest Rates from Bank of England
After being dragged down by the outbreak of Foot and Mouth disease, the British Pound powered back today on the strong likelihood that the Bank of England will be raising interest rates by at least 25bp over the next few months. In their Quarterly Inflation Report, the BoE pointed out that rising oil and food prices will keep inflation above their target for the next 2 years. If they do not fall, then the “upside risk to inflation” would be “crystallizing.” The continued hawkishness of the BoE will be positive for the GBP/USD and negative for EUR/GBP. UK trade balance is due for release tomorrow morning. The strength of the British pound should weigh on exports.

Reserve Bank of Australia Raises Interest Rates, Remains Hawkish; Employment Reports Up Next
The Australian dollar rallied today on the combination of US dollar weakness and hawkish comments from the Reserve Bank of Australia. The central bank raised interest rates to 6.50 percent last night, which was widely expected, but their degree of hawkishness hinted at the possibility of another rate hike by the end of the year. This helped to rally both the Australian and New Zealand dollars. Employment reports are expected from both countries tonight; the labor market should continue to remain tight. The Canadian dollar also strengthened on the back of US dollar weakness. They have housing market reports due out tomorrow.

Euro Heads Back Towards Record Highs
The Euro came within 30 pips of its all-time highs today on the back of broad dollar weakness. Both the German and French trade balance was weaker than expected in the month of June. The French trade deficit remained unchanged at -3 billion while the German trade deficit shrunk from 17.3 billion to 16.5 billion. The current account balance for the same month, however, was much stronger than expected, at 16.6 billion versus 8.9 billion the prior month, thanks to an increase in both exports and imports. Meanwhile the economic conditions in Switzerland continue to be good with the unemployment rate remaining at an extremely low 2.7 percent. This has helped the franc outperform the Japanese Yen.

Kathy Lien is the Chief Currency Strategist at FXCM.