Carry Trades Continue to Sell Off as Dow Tumbles Below 13k on Red Letter Wednesday
Big moves in the US stock markets are driving major losses in carry trades. Most of the Japanese Yen crosses are down between 1 to 3 percent on the day with the losses in the carry basket that we are monitoring, which consists of the three highest yielding currencies against the three lowest yielding currencies quickly closing in on the third biggest drawdown since the inception of the Euro. This was back in May, 2004, when the basket fell by 7.6 percent. With the exception of the Japanese Yen, the dollar is up across the board as investors continued to bail out of risky assets and move back to cash. Today is known as the “red letter day,” which is the last opportunity that investors have to request withdrawals by the end of September from hedge funds, which usually subscribe to the standard 45-day redemption notice. Given the recent volatility in the financial markets, many investors will be looking to cut their losses and run. In order to meet these withdrawals, hedge funds will need to raise cash. With many lenders refusing to lend, the only way to raise cash would be through further asset liquidation. Large scale redemptions could continue to weigh on the equity and bond markets in the weeks to come. We are already seeing the credit crunch have a wider impact on the financial sector. Deutsche Bank and UBS were both downgraded by rival brokers. Countrywide Financial was downgraded to a sell by Merrill Lynch who added salt to the wound by warning that Countrywide could face bankruptcy. After not injecting liquidity into the financial system on Tuesday, the Fed added another $7 billion of temporary reserves today. Meanwhile, a lot of US economic data were released but that seemed to matter little to a market that has already priced in an interest rate cut on September 18. Consumer price growth and industrial production were right in line with expectations, foreign purchases of US securities was mixed, Empire State was very hot, but the NAHB housing market index plunged to 16-year lows. If the Federal Reserve needs an excuse to cut interest rates, they probably already have one. More housing market data and the Philly Fed survey are due for release tomorrow. The market will probably be focusing more on housing starts and building permits than the manufacturing sector index.

Japanese Yen Continues to Outperform All of the Majors
After being brutally beaten down over the past few years, the Japanese Yen has returned with a vengeance. Like the Standard and Poor’s 500 Index, most of the Yen crosses have now erased all of its year to date gains. The losses today have been extensive with AUD/JPY and NZD/JPY both down over 2 percent. Yesterday, we indicated that retail traders were still going long, but the new lows reached today have stopped many of those traders out. Whether or not carry trades continue to sell off will be partially dependent upon whether the Nikkei breaks lower tonight as well. There is no major economic data due out from Japan this evening. The turmoil in the markets has pushed the chances of an August 23 rate hike by the Bank of Japan from 37 percent yesterday down to 20 percent today. It will be interesting to see if the Bank of Japan continues to add liquidity to the system as well. Finance Minister Omi said last night that the worst of the home loan crisis may be over.

Sharp Losses Continue for the Australian, New Zealand and Canadian Dollars
Next to the Japanese Yen crosses, the biggest losers were the Australian, New Zealand and Canadian dollars. More Australian hedge funds are being hit by the US subprime crisis. Basis Capital told investors today that one of its hedge funds have lost over 80 percent of its value. As of March, the fund had a $1 billion in holdings, which means that now they probably now have less than $200 million. More skeletons will probably becoming out of the closet as the hedge funds in Australia prove to be up to their necks in risk. The New Zealand dollar is tracking the Australian dollar lower, having sold off aggressively for the past five trading days. The Canadian dollar also continued lower on the back of continued weakness in economic data. We could see a bounce in the CAD however after Coventree announced that they have found buyers for their asset backed commercial paper, which suggests that they may lift their funding freeze. The Bank of Canada also injected further liquidity to calm the markets.

British Pound Slips as Bank of England Moves Further Away from Raising Rates
The British pound dropped for the third straight day in a row after the minutes from the latest Bank of England meeting revealed a unanimous vote to keep interest rates unchanged. According to the minutes “"Most members emphasized that they had no firm view on whether rates needed to rise further." Rate hike expectations have already been downgraded after the surprisingly soft consumer price report released yesterday. The lack of support for a rate hike at the last meeting pushes the central bank even further away from raising interest rates to six percent by the end of the year. Do not be mistaken however as the market has not given up on hope for another rate hike, especially after Bank of England member Sentence stressed that one consumer price report will not mean much to the BoE. Meanwhile, UK employment data was slightly worse than expected with average earnings including bonuses declining in the month of June and jobless claims falling less than expected.

Dollar Rally Takes Euro to Fresh Monthly Lows
Flight to safety continues to drive the US dollar higher against the Euro. Over the past five trading days, the Euro has fallen close to 400 points. It appears that the European Central Bank’s attempts to calm the markets have done little to ease market fears as bad news continues to hit the headlines. Yesterday, ECB President Trichet said that conditions are normalizing which explains why they did not inject liquidity into the financial markets this morning. If another piece of bad news hits the wires tomorrow, they may have to add more liquidity.

Kathy Lien is the Chief Currency Strategist at FXCM.