US Dollar: Risk Aversion Returns as Stocks Fall Over 280 Points, Fed Needs to Cut Rates
What happened to summer range trading? On Friday and Monday, everyone talked about how the markets would be completely dead with many UK and US traders taking the entire week off. Although some would argue that the markets are still stuck in their 2 week trading range, the gravity of today’s 280 point sell-off in the Dow, 350 point move in CAD/JPY and AUD/JPY, is the opposite of what the definition of quiet summer ranges should be. US stocks have been in the red since the beginning of trading, but today’s liquidation exacerbated after the release of the FOMC minutes. The minutes did not contain anything surprising since the meeting was held before the August 16 emergency conference call and the August 17 discount rate cut. The minutes only revealed that the Fed already concerned about credit problems and were prepared to act if the credit crisis worsened. On August 7th, the Dow was still trading at 13500 and USD/JPY was at 118.50. The breakdown today was a direct result of bad news upon bad news hitting the wires. According to the S&P/Case-Shiller survey, in the month of June, house prices dropped by the largest amount on record yoy. Consumer confidence also saw its largest drop since Hurricane Katrina in September 2005. The index fell from 111.9 down to 105.0 in the month of August. Weaker consumer confidence is hardly as consumers watch their paper wealth evaporate at a time when interest rates on credit cards and mortgages are also rising. The Financial Times had an article today talking about the rise in credit card defaults as well as late payments. This is usually the first sign that US consumers are feeling pinched in a major way. Over the next 2 months, this will create a big drag on consumer spending. If retail sales starts to deteriorate materially, then the US economy may be flirting with a recession, at which point the Fed would have to deliver at least 75 to 100bp of easing in order to save the economy. These are real problems that aren’t going away anytime soon. Bernanke cannot afford to not be proactive at a time when deteriorating US fundamentals is driving old fashioned risk aversion.

Carry Trades: More Losses to Come
The Japanese Yen has surged against every major currency pair as the market resumes broad scale carry trade liquidation. As usual, stop losses have exacerbated the moves lower in the yen crosses. Volume is thin this week and many banks only have junior traders left on their desks. These traders are not likely to take on any news positions and are there just to monitor levels, book trades and watch for stops. Taking on risk is the last thing that senior dealers want their junior dealers to do at this time. As a result, any rebound in carry trades could be limited. No economic data has been released from Japan overnight and none are scheduled for release over the next 24 hours. Carry trades should continue to remain weak until risk appetite returns to the market. Technically the corrections in many of the Yen crosses are now over which means that the downtrend has resumed. Meanwhile Japanese traders are also happy that their unpopular government is trying to change for the better. Prime Minister Abe has appointed a number of veterans to his new Cabinet who will hopefully push through some positive changes.

European Banks Still at Risk
Flight to safety sent traders pouring back into US dollars pushing the Euro lower for the second day in a row. German business confidence (the IFO survey) dropped to a 10 month low in August. Although businesses were more optimistic about current conditions, their expectation of business conditions in the months to come continued to deteriorate. There has been a lot of talk that German banks are practicing the silence policy on subprime related losses. If true, this would be pretty dangerous since the problems will eventually be revealed when earnings are released. ECB member Bini-Smaghi made cryptically convoluted comments today. He said that the markets had correctly interpreted yesterday’s comments by ECB President Trichet. Unfortunately Trichet was completely noncommittal about a September rate hike and simply said that the ECB would decide what to do with interest rates at the monetary policy meeting and not anytime beforehand. Meanwhile the Swiss UBS consumption index dropped to 2.261 from 2.311. This suggests that the KoF index of leading indicators, due out tomorrow could also suffer.

British Pound Breaks 2.00
The British pound broke below 2.0 as rising risk aversions sent the US dollar higher. The only piece of economic data released from the UK this morning was the July BBA mortgage approvals which fell from 75k down to 67k. The pace of deceleration has slowed which is mildly encouraging. With no economic data due for release tomorrow, continued concerns about the subprime sector and losses in the US stocks will dictate whether we see further losses in the British pound. Meanwhile keep an eye on GBP/JPY.

Sharp Reversal in Australian, New Zealand and Canadian Dollars
The Australian, New Zealand and Canadian dollars all came under heavy selling today as traders piled out of high yielding currencies. The market seemed to care little about the stronger than expected Australian and New Zealand data. Australian leading indicators increased 0.4 percent while third quarter inflation expectations in New Zealand rose to 2.64 percent from 2.58 percent. In what could be construed as mildly hawkish comments, RBA Deputy Governor Battellino said that recent liquidity injections did not represent a change in monetary policy. In contrast BoC Deputy Governor Duguay was far more cautious about the global financial situation, which suggests that the central bank will keep interest rates unchanged next month.

Kathy Lien is the Chief Currency Strategist at FXCM.