Gain Capital

The USD dollar recovered sharply this past week, but the major development looks to be the meltdown in carry trades, most clearly evident in a collapse in the JPY-crosses. In last week’s update, I cautioned again that the increase in risk aversion emanating from the debt/credit markets was likely to spread to equity markets, and that this might prove to be the trigger to a carry-trade sell-off. My worst case expectation that M&A/LBO associated debt issues would not find receptive buyers looks to have transpired, with debt issues for KKR’s acquisition of Alliance Boots being shelved until conditions improve. (The next touchstone of debt market receptivity will come next week when a smaller tranche of KKR/Boots debt is set to go on sale, having been delayed from this week and re-priced with higher interest rates to attract reluctant investors.) That news came out on Wednesday and unnerved equity markets, but the major sell-off came on Thursday, and sent investors the world over running for the exits.

I also mentioned in last week’s report that the JPY-carry trade unwinding this time around was not likely to see the same sort of rebound (and further gains actually) that occurred after the last wipeout at the end of February. For many months now, we have been discussing internally what it would take to end this cycle of carry trades. Our conclusion was that it was most likely to be a major shock to the financial system, though we had envisioned widespread hedge fund losses or a financial institution failure as the most likely source of that shock. The credit crunch that has materialized out of the sub-prime mortgage market in the US looks to be the ultimate culprit, affecting as it does funding conditions for nearly every major market.

More importantly, it goes right to the heart of the basis for the carry-trade, namely easy credit and risk-seeking behavior. Of course, the interest rate differentials remain the same, so the fundamental basis for the carry trade is still intact. But the environment that allowed the trade to succeed and grow in popularity, low volatility, easy credit conditions, has been seriously undermined. While it’s too soon to say with any certainty, the continued pressure on the JPY-crosses into the end of the week suggests further unwinding is still to come.

Turning back to the USD, the dollar weakness that had been evident since the beginning of June looks to have finally ended. The USD index came within two ticks of dealing at the pivotal psychological and long-term support level of 80.00. It then rebounded sharply and looks set to close out the week just shy of 81.00. In the process, EUR/USD and GBP/USD fell below key trendline supports and they look set to see further weakness against the USD. The higher-yielding commodity currencies (AUD, NZD, and CAD), also took it on the chin on a combination of JPY-cross selling and breaks of key uptrend supports. Part of the selling in those pairs came as USD/JPY rebounded sharply on Friday from lows just above 118.00, leaving the path of least resistance to selling JPY-crosses as the selling of the non-JPY component against the USD.

Japanese officials are justifiably concerned over the pace of the JPY’s appreciation this past week, and are likely to seek to stabilize it in the weeks ahead. The Ministry of Finance (MOF) enjoys the greatest influence over the USD/JPY rate and that looks likely to consolidate between 118.00-120.90. Keep in mind that USD/JPY has dropped through the Ichimoku cloud support and this represents a shift to the downside in the overall direction of USD/JPY. The cloud is now above at 120.90 and this should serve as the upper limit of any correction.

On Sunday, Japan will hold upper house elections and the ruling LDP coalition looks set to lose its majority there, which is mostly a symbolic defeat reflecting PM Abe’s low approval ratings. Markets are well aware that PM Abe is likely to suffer badly, but don’t seem too concerned about it as LDP sources have indicated Abe won’t resign no matter how bad the result. Should Abe and the LDP fare as poorly as expected and Abe steps down to accept responsibility for the losses, political uncertainty would weaken the JPY in the short-term. Such a result would also further delay expectations of an August BOJ rate hike, adding further weight to the JPY. However, carry trade unwinding is likely to provide plentiful selling interest on any rebounds in USD/JPY, so I expect any USD/JPY rallies to be short-lived. Election results should be known before the Sunday opening, so there is a risk of USD/JPY opening higher than today’s close around 118.60. Also worth noting, USD/JPY formed a long-legged doji on Friday, a sign of indecision in the current downmove.

Volatility has finally returned to financial markets after an extensive absence. The current bout of volatility looks to be more than a flash in the pan, so I would expect continued short-term volatility to continue. In the Forex market, additional JPY cross-selling coupled with overall USD buying is likely to make for further challenging trading conditions. Equity markets will continue to be the main proxy for JPY direction, which will continue to drive the other USD pairs. Data reports in the coming days will likely be less important than the market reaction to them. Should softer USD data fail to see any significant USD selling, it’s a strong signal that USD shorts are still being covered. Also, we have month-end in the middle of next week, which represents another period of reduced liquidity amid ongoing position liquidations—a recipe for even higher volatility.

Looking to next week’s data and events, both the ECB and the BOE are holding rate setting meetings. The BOE is not expected to raise rates again and I continue to expect further unwinding of UK rate hike expectations to weigh on GBP, as signs of further slowdowns in housing price gains and retail spending undermine the case for two additional rate hikes in the current cycle. The ECB might signal a September rate hike with the use of the term ‘vigilant’ in the statement following an expected steady decision on Thursday. There may be some speculation of that next week, and it might be enough to steady the EUR/USD above the key 1.3560/70 support zone. However, given the current state of disarray in global financial markets, as well as increasing signs that Eurozone growth is cresting, the ECB is likely to stay silent on the timing of the next rate move, pushing off expectations of the next hike to October. There is also a sizeable amount of interest rate expectations built into the current EUR/USD rate that also needs to be priced back out. Added together, I look for the EUR/USD to decline on delayed and reduced interest rate expectations over the next several weeks, with the 1.3560/70 the key pivot to fresh weakness.

The US data calendar kicks off on Tuesday with personal income and spending, PCE (personal consumption expenditure) core inflation reading (the Fed’s preferred inflation gauge) and July Chicago PMI and Consumer Confidence. Wednesday sees the ADP July employment report, June pending home sales, and the July ISM manufacturing index. Thursday sees weekly jobless claims and June factory orders. Friday sees the July NFP report, with current estimates focused on 130K increase in jobs and a steady unemployment rate of 4.5%. Friday concludes with the ISM non-manufacturing report.