Large scale liquidation of carry trades continued overnight. News that Countrywide Financial tapped its entire $11.5 billion credit facility and Canada?s Coventree failed to find buyers for its asset backed commercial paper exacerbated concerns that the liquidity crunch isn?t going away despite over $300 billion worth of liquidity injections from central banks around the world. The Japanese Yen crosses weakened throughout the night, but the selling quickly picked up pace around 6:30am EST when USD/JPY broke below 115.00; in less than 10 minutes, the currency pair fell 150 pips to hit a low of 113.59.
The other yen crosses which are linked to the value of USD/JPY followed suit with pairs like GBP/JPY and AUD/JPY falling 300 pips within a matter of minutes. From yesterday?s London close to today?s low point of 76.70, NZD/JPY saw its biggest percentage decline in 22 years. However as carry trade liquidation hits an extreme, the selling may soon come to an end.
[B]Speculators are Already Shaken Out[/B]
According to the latest FXCM Speculative Sentiment Index, open positions in the Japanese Yen are down 15 percent overnight. Banks are also reporting that Japanese retail FX traders have reduced their positions by more than 80 percent which suggests that Mrs. Watanabe is getting shaken out by the recent moves as well. Who?s to blame her for bailing given the fact that GBP/JPY fell 700 points from its high today and 1200 points since the beginning of the week. These losses far outweigh any interest income. The liquidation however was not limited to the Yen crosses as the Australian dollar and New Zealand dollar both fell over 3 percent against the buck. Flight to safety continues to benefit the US dollar as traders are forced to close out their risky positions and move back to cash. Yesterday was “red letter Wednesday” when investors had their last opportunity to demand their money back by the end of September. Hedge funds will have to raise cash to meet these withdrawal requests by liquidating their assets. We are already seeing triple digit losses in the Dow. Also, margin calls in general have taken a lot of traders out of the markets. As of close of business today, the CME and CBOT will be increasing their margin requirements on some currency, interest rate, and stock-index futures which mean that regular retail investors will also have to fork up more cash (which they may not be willing to) or bear the pain of margin calls. Once most of speculators are stopped out, that is typically when we have a bottom in periods of liquidation. Therefore we expect a few hundred point bounce in the Yen crosses over the next few days. However given the gravity of today?s moves a bounce will not negate the overall downtrend which is true even if USD/JPY manages to rally back up to 118.
[B]How Significant are the Moves today?[/B]
[B]Chances of an Intermeeting Rate Cut by the Federal Reserve[/B]
Federal Reserve President Poole seems to be very off point when he said last night that the market losses have not had a “real impact” on the economy. The liquidity crisis is forcing companies to layoff people left and right. Just this morning, Biotech giant Amgen announced that they will be reducing its workforce by 12 percent. Poole also added that only a “calamity” would justify an emergency interest rate cut. Although we do not think that the Federal Reserve will deliver an intermeeting rate cut, we do think that the Federal Reserve will have no choice but to cut interest rates when it meets on September 18. Since 1994, there have only been 4 intermeeting rate cuts, once in 1998 and three times in 2001. The sharp increase in risk in October 1998 is the closest match to today?s credit crisis. Back then, the Federal Reserve surprised the market with an intermeeting cut a few months after Russia?s debt default and the LTCM crisis. The main reason for the intermeeting cut at the time was the potential impact on the “real” economy. Poole?s comments yesterday suggests that at least one member of the Fed does not hold this view.
[B]Central Banks Continue to Inject Liquidity[/B]
In the meantime, central banks continued to inject liquidity into the financial markets. The Federal Reserve added $19 billion in reserves this morning through two separate operations. Last night, the Reserve Bank of Australia added A$3.04 billion while the Bank of Japan added Y400 billion. There was a great deal of volatility in the Australian and Japanese financial markets overnight. At one point, the Australian stock market was down 5.3 percent, which was the biggest one day decline in 7 years. The Nikkei also broke below 16,000 for the first time since November 2006. Both indexes eventually retraced a good part of those losses to end down slightly more than 1 percent. The ECB has yet to inject liquidity today. Even though these central banks have far more money to inject into the financial systems, at some point, they may have to buckle down and lower interest rates, starting with the Federal Reserve.
[B]Relevant Articles:[/B]
Helicopter Ben Faces His First Financial Crisis: What Will He Do?
How Long Does Carry Trades Liquidation Take to Recover?
The carry basket is currently down 7.1 percent and at its low point, matched the decline in May 2004.
Written by Kathy Lien, Chief Strategist and David Rodriguez, Currency Analyst