Big Rally in Carry Trades and Dow Despite Bad Data: What Is Happening?
Carry trades rebounded strongly as the Dow came close to erasing all of Tuesday’s losses. The only piece of economic data released from the US was mortgage applications which dropped for the second week in a row. Any news from the financial sector only provided more cause for concern. UK hedge fund Cheyne Financial may be forced to liquidate up to $6B in assets due to losses in the commercial paper market while Basis Yield Alpha Fund filed for bankruptcy. Everyone is also beginning to shift their focus to this quarter’s earning releases. Moody’s and Standard and Poor’s both warned that banks could suffer double-digit losses due to falling revenue and big write offs. So why has the Dow rallied so much today? There are only two real explanations. The first is that the market expects tomorrow’s second quarter GDP report to be revised up sharply. Although a valid reason, the backward looking GDP report does not reflect the recent turmoil that we have had in the financial markets. The second explanation is Bernanke’s comment that there is no need to lift portfolio caps on Fannie Mae and Freddie Mac. This could suggest that the Fed has other ways to boost growth and may not need to resort to raising portfolio limits on GSEs. The lower volume in the market is also contributing to the unusual swings in the currency and stocks markets and because of this, it is not time to become complacent. The problems are increasing as risks continue to grow, but traders are simply ignoring them. Judgment day will come after the Labor Day holiday in the US. The slide in the dollar today indicates that risk appetite is returning, but for the time being, the downtrend in most of the high yielding currency pairs remains intact. The rallies that we have seen so far should only be perceived as a rebound within an overall downtrend.

Euro: Watch for a Break of 1.37
Even though the Euro started the week on a softer footing, it has now recovered close all of those losses. German and French unemployment numbers are expected to be strong tomorrow even though retail PMI across the region should be weak. German consumer confidence has already deteriorated for the month of September. However these economic releases will most likely be only secondary triggers for moves in the Euro. Instead, all eyes will be on US data, the credit markets and any comments from ECB officials. So far, the central bank has kept us guessing on what to expect in September. Meanwhile the Swiss KoF leading indicators report deteriorated from 2.09 down to 2.06 in the month of August. Swiss economic data has been on a downtrend, which suggests that the central bank will leave interest rates unchanged next month.

British Pound: A Puppet of the Risk Appetite
There was no economic data released from the UK today and the only news out the country was a bad one since Cheyne Financial is a UK based hedge fund. Yet, the British pound rose strongly against the Euro, US dollar and Japanese Yen which means that the currency was nothing more than a puppet of global market risk appetite. Tomorrow may be a bit different however with Nationwide house prices, consumer credit, mortgage lending, money supply and the CBI distributive trades survey all due for release. Housing market reports should be a bit softer after the drop in mortgage approvals reported yesterday. Meanwhile keep an eye on the CBI survey since it tends to be a good leading indicator for retail sales. Both of these reports are expected to be weaker which means that the British pound could give back some of today’s spectacular gains.

Yen Selling Resumes Once Again
The currency market seems to be extremely schizophrenic at the moment as they love the yen one minute and hate it the next. Over the past few days, the Japanese Yen crosses have been swinging 10 to 20 pips at the blink of an eye. This may of course be due to lower volume, but at the same time, it is also due to uncertainty. Traders are waiting for the next shoe to drop and depending upon whether that will comes in the form of another big blowup or an interest rate cut by the Federal Reserve first will determine where the Yen crosses are headed next. For the time being, we prefer to err on the side of caution and avoid jumping into the carry trade. Meanwhile Prime Minister Abe’s Cabinet Shakeup has helped to boost his approval ratings significantly. For the first time since May, his approval ratings were above 40 percent. Japanese retail sales are due for release tonight along with small business confidence. Both figures are expected to be weak.

Demand for High Yielders Drive Australian, New Zealand and Canadian Dollars Higher
Renewed demand for high yielding currencies as well as rebounding oil and gold prices have driven the Australian, New Zealand and Canadian dollars higher. Australian new home sales and construction work data was tepid, but that seemed to matter little to the currency market. Instead traders revealed in higher oil prices after the larger than expected drop in crude inventories and in the market’s overall demand for yield. Over the next 24 hours, we are expecting a lot of data from these 3 countries. Australia will be reporting its current account figures, New Zealand has its money supply and business confidence data while Canada has industrial and raw material prices along with its current account balance; expect these currencies to be in play tomorrow. Meanwhile Australia and New Zealand could weather the US slowdown better than many people may think. The Baltic Exchange’s Dry Freight Index was once termed, the “Best Economic Indicator You’ve Never Heard Of” by Daniel Gross hit a record high today. This indicates that there continues to be huge demand for raw materials from countries like China and India. This could provide the support that these commodity rich countries need

Kathy Lien is the Chief Currency Strategist at FXCM.