Dow Stages Impressive Comeback, Dollar Skyrockets on Rising Risk Aversion: Will the Fed Still Cut Interest Rates?
Volatility rocked the markets as the Dow plummeted as much as 340 points intraday before reversing to settle down only 15.69 points. Today’s move is nothing short of impressive and suggests that at least for the time being, US stocks and carry trades have hit a short term bottom. However everyone from hedge funds to Mrs. Watanabe has probably been shaken out. Given the massive losses incurred over the past few days, speculators may simply not have enough money or the stomach to get back into the markets and try to pick a bottom especially since the CME and CBOT increased margin requirements on some currency, interest rate and stock-index futures. These days, cash is a valuable commodity since a liquidity crisis means a lack of cash. The sharpness of recent moves and the lack of liquidity have probably pushed more traders to liquidate positions than to add funds. Flight to safety continues to send the dollar higher against every major currency with the exception of the Japanese Yen as more victims of the subprime and liquidity crisis surface. First Magnus Financial Corp, the nation’s 16th largest mortgage lender announced that it stopped taking mortgage applications. National City Corp shut down its home equity unit while Countrywide Financial tapped its entire credit facility in order to continue operations. The Federal Reserve, Reserve Bank of Australia and Bank of Japan have all responded with liquidity injections today. Even the Russian central bank added reserves to their financial system. Despite the sharp reversal of earlier losses in stocks, the biggest question on everyone’s mind is when the Federal Reserve will cut interest rates. The market is current pricing 75bp of easing by the end of the year. There has also been speculation of an intermeeting rate cut. Like many central banks around the world, the Fed has been reluctant to lower rates because they feel that the markets need to be punished for their excessive risk appetite. Furthermore, they have said that they need to see market volatility have a “real impact” on the economy. Between now and the next Fed meeting on September 18, there is plenty of economic data due for release. With major losses and bankruptcies reported throughout the financial sector, we expect companies to layoff staff left and right. Even Biotech giant Amgen announced today that they will be reducing their workforce by 12 percent. For the people in the “real economy,” their 401ks have taken a harsh beating while their mortgage interest payments are on the rise. It is only a matter of time when we see economic reflect that. The bad news is already pouring in with housing starts hitting a 10 year low and manufacturing activity in the Philadelphia region stagnating. Since the beginning of the year, the weak dollar has provided a big boom to the manufacturing sector. Now that the dollar has strengthened significantly, activity in the manufacturing sector should also begin to slow.

Japanese Yen Crosses Get Decimated, but Is the Sell-off Over?
The Japanese Yen surged to fresh monthly highs against all of the majors. The last time we saw trading ranges of this magnitude was back in October 1998 which was the year that Russia defaulted on its debt and Long Term Capital faced major losses. At the time, the Federal Reserve responded with multiple interest rate cuts. The moves over the past few days still pale in comparison to the moves in October 1998 where EUR/JPY fell 2,878 pips over the course of a four trading days. Since August 9, from high to low, EUR/JPY is down only 1,526 points. The VIX index also jumped to the highest level since 2003, which means that traders in general remain risk averse. However the late afternoon rebound in US stocks suggests that we could see a similar rebound in the Yen crosses as long as the Nikkei does not collapse. However even if we do see a few hundred pip reversal in the Yen crosses, that would not necessarily erase the overall downtrend. Instead, traders need to continue to exercise caution in current market conditions. Big moves like today is one of the main reasons why it is important to use stops and low leverage.

Australian Dollar Breaks below 80 Cents, New Zealand Dollar Below 70 Cents
The Australian and New Zealand dollars were the biggest losers in the currency market today. The Australian dollar is down 5 percent against the Japanese Yen and 3 percent against the US dollar. The New Zealand dollar on the other hand is down 4 percent against the Yen and 2.5 percent against the US dollar. Both currencies have been hit hard by carry trade liquidation as Mrs. Watanabe cuts her losses. At this point, the loss due to currency fluctuations far outweigh the interest rate gains. In fact, AUD/JPY is one of the only Yen pairs to fall more in this phase of liquidation than it did back in 1998. Overnight, the Australian stock market plummeted as much as 5 percent, which was the largest one day decline in 7 years. From high to low, the 2-day decline in NZD/JPY is the biggest in 22 years. The Canadian dollar on the other hand has been spared even though international securities transactions were much weaker than expected.

Stronger UK Retail Sales Fails to Help the British Pound
Liquidation of high yield currencies has sent the British plummeting alongside the Australian and New Zealand dollars. GBP/JPY had a 1000 point trading range today and is down 500 points on the day. Stronger than expected retail sales last month did little to help the currency on a day when traders were focused on nothing but for liquidation. However, if the majors were to bounce over the next 24 hours as suggested by the strong reversal in the Dow, then the British pound could be one of the biggest beneficiaries given the strength of today’s economic data.

Euro Manages to Recapture All Prior Losses Against the Dollar
The Euro ended the day unchanged against the dollar, after having recaptured all of today’s losses. Unlike the Fed, the ECB did not add liquidity to the financial system. So far, the ECB has shown no sign of canceling their planned rate hike in September.

Kathy Lien is the Chief Currency Strategist at FXCM.