Further reduction in risk appetite resulting from added downgrades in sub-prime backed US securities continues to boost the yen as flows return to the Japanese currency, which served as a financing for higher yielding FX and rising equities.
The sharp break in the yen carry trade is at its most significant since the events of February 27 through March 4, as the yen gains 2% vs. the dollar in two days, compared to 4.5% in two weeks in late February and early March.
The notable distinction from the events of four months ago is the broad sell-off in the US dollar currently underway as manifested in the three-day rally in gold prices to four-week highs, resulting from concerns about the US economy. Indeed, the global market correction of four months ago was not only a U.S. phenomenon, but also a result of a 9% drop in China's stock market, which triggered an all round global correction. At that time, the dollar rallied against the euro, sterling, Aussie and Kiwi while gold prices fell sharply as reduced risk appetite unwound those dollar shorts.
This week's events bear risks that are specific to the U.S. dollar as the latest subprime revelations weigh on consumers: falling home prices and anticipated mortgage resets; companies, depending on construction and home improvement; and banks/hedge funds that are holding downgraded paper.
Our case for a 2007 rate cut has been capital market-oriented as well as macro-oriented. The capital market rationale is highlighted by reduced risk appetite affecting liquidity in a highly leveraged financial landscape, which spells the probability of contagion. The risk of such contagion can occur via the following:
1) A sharp rebound in the yen would jeopardize billions of dollars worth of what were initially low cost yen loans;
2) Higher interest rates on U.S. mortgage owners after interest rate resets;
3) Deterioration in the values of sub-prime securities as these are unloaded from the portfolios of banks and hedge funds.
USD/JPY rebound caped at 122.10A USD/JPY rebound is seen stabilizing at the 122.10 area, which could take place on the heels of a recovery in US equities. But the yen’s gains and dollar weakness are becoming more of structural in nature, suggesting renewed losses to tackle the 121.60 and 121.20 targets. Key foundation stands at 120.75.
Watch gold and stocks for clues on EUR/USD
While a rebound in U.S. equities is seen boosting the euro on the arguments that rising returning risk appetite helps open fresh euro longs, a decline in U.S. equities may not be as negative for the euro as it was proven to be the fact in previous episodes. Traders must watch the prices of gold. If we see a decline in equities accompanied with rising gold, then this reflects a sign of reduced risk appetite coupled with overall dollar weakness from subprime woes. A drop in equities coupled with a decline in gold may not be as euro supportive.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
140 Broadway, 30th Floor
New York, NY 10005
(212) 644-4220
a.laidi@cmcmarkets.com
