Gain Capital

The US dollar is closing slightly weaker against European currencies and down more significantly against the JPY, which translates into a lower weekly close for the JPY-cross carry trades. The USD continues to be seen as vulnerable against the backdrop of the losses in the mortgage-backed securities market. Despite those concerns, US stock markets DJIA and S&P) reached new all time highs, but were unable to sustain the gains on the last trading day of the week. The equity sell-off weighed on USD/JPY and JPY-crosses, and provided the only major excitement for the week.

Last week I suggested that the US dollar’s decline had reached a likely period of consolidation against European currencies (EUR, GBP, CHF) with a decent potential for a rebound. This past week’s price action was largely consolidative in those pairs, with minor new USD lows being reached (EUR and GBP new highs). But there was no sign of any USD rebound, as the US dollar index looks set to close about 20 points lower around 80.30, though I would point out the pace of weekly declines in the dollar index have slowed substantially. USD/JPY was responsible for most of the USD’s on-week declines in the index, and this is the result of rising investor risk aversion in the wake of the mortgage-backed securities market, coupled with equity market declines.

While I remain convinced that sub-prime market problems are unlikely to spill over into the larger US economy and remain largely confined to the institutional investor community, ongoing deterioration in credit spreads, rumors of major losses, and position adjustments appear set to continue for the foreseeable future and will continue to cast a shadow over the USD. In that environment, it will be difficult for the USD to stage any rebound of consequence. The most likely scenario for a spill over into other markets is further investor flight to safety/quality, and that augurs poorly for further gains in equity markets. However, keep in mind that while the root cause of mortgage-backed losses is the US housing market, the fallout is not confined to strictly US investors. Global asset managers and financial institutions are heavily exposed to the US mortgage-backed security market and will not escape unscathed. As a result, global equity markets in general may be in for a tough road ahead. The major risk in this regard is that a further contraction in credit conditions disrupts previously announced LBO/M&A deals or scuttles others in the works. The global M&A frenzy is a major factor behind the recent run-up in share prices worldwide, and if that apple cart gets upset, equities may be in for a serious rout.
For the major currencies, global financial market unease equates with rising risk aversion, which increases the potential for sharply higher volatility, which in turn represents a serious threat to the continuation of carry trades, most clearly in the JPY crosses. We got a taste of this on Friday, and while JPY-crosses have experienced similar set-backs in recent weeks, it feels like the shake-out might not be viewed as a buying opportunity this time around. I will be closely following the JPY and JPY-crosses in the next few weeks as I think they will supplant USD weakness as the primary theme in the currency market. USD/JPY, in particular, suffered some technical damage as it fell into the support zone known as the Ichimoku cloud. The top of the cloud is around 122.00 and will now act as resistance if the course lower is to be continued. The base of the cloud is located at 120.65/70, and a drop through that level shifts the overall focus of USD/JPY lower.

In the midst of all the concerns over credit issues in derivative debt markets, investors have been flocking into sovereign bonds in a flight to quality response. That shift has seen 10 year benchmark yields spreads move in favor of the USD against the EUR and GBP, and in favor of the JPY against all. Another shift in interest rate markets has seen expectations reduced for two further rate hikes out of the ECB and BOE. Interest rate futures continue to price in another rate hike from each, but expectations of a second rate hike have now been pared back to about 60% from nearly 100% just a week ago. With EUR/USD and GBP/USD far closer to their highs against the USD, it would seem the currency market has yet to adjust pricing accordingly. Those interest rate expectation adjustments were based on incoming data that continues to suggest Eurozone growth has likely crested, while UK data indicators point to a further ebbing of the extremely bullish outlook. I think the upside for the EUR/USD and GBP/USD remains constrained as a result, and I prefer to continue to trade them from the short-side on remaining rallies. At the same time, I’m circumspect about their downside potential while the gloom hangs over the USD, and I’ll look to take profits opportunistically. The downside for those currencies increases with a further pressure in the JPY-crosses.