Global Deleveraging Decimates Carry Trades

10/27/2008 9:08 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

What a difference a week makes. My expectations for some sense of stabilization in financial markets were utterly obliterated this week as stock markets worldwide plunged in unprecedented fashion. The main driver was global deleveraging, which boils down to selling assets of every stripe, with stock markets as the primary recipient of the pain. Markets have been deleveraging in earnest since mid-summer, but the latest wave down in share prices has come against a backdrop of worsening economic outlooks in all major economies. This has seen the latest round of selling hit emerging markets especially hard, with Asian and European shares getting pummeled as well. This latest wave of selling reeks of capitulation and panic, along with forced liquidations by asset managers and hedge funds, but so have prior sell offs in recent months. This leaves me and many other feeling as if there is no end in sight, though I remain mindful of upcoming government initiatives (e.g. TARP, commercial paper buying fund, and even talk of lowering the Fed's reserve requirements) that have the potential to bring some relief. What's different this time seems to be how the selling has cycled around to hit non-US markets to a greater extent than prior rounds of deleveraging, which may indicate that the deleveraging process is closer to an end. There is also the timing of the current sell off. October is a historically ugly month for stock markets, and this is aggravated by hedge fund redemptions due to be paid in November leading to additional selling in October. But with ongoing deterioration in economic data and outlooks, as well as investor withdrawals (redemptions), there is clearly more potential for continuing liquidations. That leaves me in default mode, where the operating premise is that things will get worse until they get better.

In forex markets, stocks are continuing to drive currencies, and this is most evident in JPY crosses (carry trades) collapsing lower, and the USD surging against all but the JPY. Rattled stock markets will continue to drive FX in the week ahead, with likely soft incoming economic data potentially adding more fuel to the selling. Volatility will likely remain exceptionally high, which makes positioning extremely difficult to maintain, so traders are likely better off reducing position sizes and anticipating larger swings in prices. There has been a fair amount of talk that recent FX volatility may spur intervention by key central banks, but comments from Japanese officials, who would be the most likely to intervene by selling JPY, indicate a reluctance to step into the market, because they don't think it would be effective until share prices stabilize. In any event, only coordinated intervention by the G3 (Fed, ECB, and BOJ) seems likely to have any lasting impact on currency markets. Should intervention occur, the central banks would be selling JPY and USD against other major currencies.

Technical Guide Posts for Key Currency Pairs

A lot of technical damage has been done in all major currency pairs. To gauge whether recent moves are set to extend or reverse, I'll be watching the following price levels in key currency pairs:

    * EUR/USD—The downside remains in play while below 1.2720-50 area, which is a key Fibonacci price area where the move down from 1.6030 to 1.3780 equals the move down from 1.4880. Sustained weakness below 1.2500 opens up potential for further declines to the 1.2200/50 area. The Fibonacci projection for the current wave down, while below 1.2720/50, is around 1.1400.

    * USD/JPY—Closed below the prior spike lows at 95.75 and the immediate downside bias remains while below there. Strength beyond 98.50 will be needed to suggest a reversal higher is underway. Weakness below 92.00/50 will likely signal a more concerted test of the 90.00/50 key psychological support level.

    * GBP/USD—The immediate downside focus remains while below 1.6100/50 and we would need to see a daily close above 1.6350 to signal a correction higher. Weakness below 1.5750 is likely to signal a test of 1.5600, which opens the door to further declines to re-test the intraday low at 1.5265. Cable has a similar Fibonacci price projection to EUR/USD, where the equivalency wave level support is 1.5965. If weakness below here is sustained, the projected price target is at 1.4450.

A Few More Lifelines for Ailing Credit Markets

The recent improvement in the credit markets came to a grinding halt on the back of the major turbulence in global stock markets. The TED spread (3-month Libor/3-month T-bill) rose 9 bps to 266 bps from the Thursday lows while the two-year SWAP/two-year T-note widened about 10 bps and is sitting near 125 bps. Both measures have worsened in the last two days after an orderly narrowing early in the week and continue to suggest the credit market problems are ongoing. Under normal conditions both should approach 50 bps.

The Fed is set to launch a program to buy commercial paper next week, and this is likely to add some relief to credit markets. Ostensibly, several dozen companies have already signed up and will be participating. The program aims to ease commercial paper market strains by offering issuers access to three-month debt directly from the Fed. Apart from easing tensions in severely frozen credit markets, this should also lend support to the economy since most businesses use short-term paper to fund recurring needs such as payrolls and other monthly expenses.

In another lifeline to markets, the US Treasury is now contemplating investments in insurers and regional banks to go along with the initial plans to buy stakes in the US's largest banks. This is yet another step that should help thaw the credit market freeze. Thus far, however, only the initial $125 billion for the big banks has been allocated and we will likely need to see these steps implemented before expecting any real improvement in spreads. Considerable improvement on these two measures, however, should see stock markets rebound considerably and JPY crosses follow markedly higher.

Key Data and Events to Watch Next Week

The US data calendar is busy next week with the FOMC meeting and rate decision on Wednesday the highlights. The consensus is that the Fed will cut rates -50 bps to 1.00% while the futures market has priced in 74% odds of -50 bps and 26% odds of a sharper -75 bps cut. New home sales kick it off for data on Monday while Case-Shiller home prices and Conference Board consumer confidence are up on Tuesday. Wednesday sees the key durable goods report and oil inventory data. Thursday has the first take on 3Q GDP and the usual weekly jobless claims. Friday rounds out the week with personal income/spending, core PCE prices, Chicago PMI, and the University of Michigan consumer sentiment index.

The euro zone calendar is also on the busy side. German IFO business surveys start the action on Monday. Tuesday has German GfK consumer confidence and French housing starts on tap. Wednesday sees German consumer prices and the European Commission holds an extraordinary meeting on the financial crisis. Thursday is busy with French producer prices, German employment, euro zone business climate indicator, and euro zone consumer confidence. Friday rounds out the week with German retail sales and euro zone employment numbers.

The UK calendar is pretty light and starts off with the CBI distributive trades report on Tuesday. Consumer credit and mortgage approvals are due up on Wednesday, while the GfK consumer confidence report rounds out the week on Thursday. Also look out for speeches by the BOE's Gieve (Monday) and Blanchflower (Wednesday).

Japan's calendar is modestly busy. Monday has retail sales data while Tuesday sees industrial production numbers. Small business confidence and manufacturing PMI are on deck Wednesday. Thursday has employment numbers, consumer prices, and the BOJ monetary policy meeting (likely another non-event). Friday closes it out with housing starts and construction orders.

Canada is characteristically light on data and kicks it off with industrial product and raw material prices on Thursday. Friday closes out the week for data with monthly GDP. The BOC's Schembri is on tap Tuesday.

It is a modestly busy week down under and it starts with Australian NAB business confidence on Monday. Tuesday sees New Zealand trade data, while Wednesday has Australian leading indicators, New Zealand building permits, and New Zealand business confidence. Thursday rounds out the week with Australian new home sales.

By Brian Dolan of Forex.com

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