Fed Statement Sends Dow, Carry Trade Lower; Turmoil to Continue?

The US dollar remained largely unchanged despite late stock market tumbles, with continued market turmoil dooming the carry trade to further drops. Better-than-expected Consumer Confidence figures left stocks relatively unchanged, but a marginally hawkish Fed text sent scares through interest rate-linked financial asset classes.

The Euro fell slightly against its American counterpart, shedding $.0020 to $1.3626. British pound markets were the hardest hit by overall market troubles, with cable dropping 90 points off of intraday highs to $2.0056. Meanwhile, the Japanese Yen continued recent gains; the dollar fell ¥1.20 to ¥114.61.
US Consumer Confidence fell by the most in two years, as well-publicized stock market tumbles and an ongoing housing recession cut optimism on future economic conditions. Indeed, the headline index dropped a sizeable 6.9 points off of July?s 111.9 print?below the three-month average of 107.4. The bulk of the change came from souring outlook on the future of growth, with the Expectations index losing 6.2 points to 88.2. The Present Situation index was similarly affected, but consumers nonetheless remained relatively upbeat about their current economic conditions. Yet it remains clear that clouded forecasts for growth may affect consumer spending through the medium term. Traders shrugged off the implications of the report, instead waiting for the later release of key Federal Reserve rhetoric.

The Minutes from the August 7 Federal Open Market Committee meeting sent shockwaves across financial asset classes, as the text shows that the Fed remained arguably unconcerned over adverse market conditions. The US Federal reserve said that a “policy response” may be needed if market rout deepened through their August 7 meeting, setting the stage for a cut of the discount rate just 10 days later on August 17. Yet the feed seemed otherwise unconcerned over recent market troubles, citing expectations that markets would return to “normal” over time. Indeed, they reiterated concerns over inflation conditions and remained “unconvinced slowdown in inflation would last”. Though they lowered GDP estimates through 2007 and 2008, the central bank seemed far from willing to respond through monetary policy accommodation through the medium term.
The FOMC Minutes had a limited impact on currency markets, as traders were largely aware of the fact that the Fed?s stance changed through their official statement on August 17th. Yet domestic equity markets saw significant tumbles on the release; stock traders were clearly hoping for a much more dovish tone through the bank?s earlier policy-setting meeting.

The Dow Jones Industrial Average lost a whopping 194 points an hour ahead of the close, while the broader S&P 500 shed 1.7 percent to 1,441. Investor sentiment was clearly rattled by the Fed?s continued focus on inflation?affecting hopes of interest rate cuts through the medium term. Unchanged implied rates on the September Eurodollars Futures contract showed largely unmoved forecasts for an imminent rate cut, however, forcing analysts to seek alternate explanations for market tumbles. It seems as though bears remain in the driver?s seat through short term trade, with stock tumbles likely to worsen before they improve.
Overall worries on the state of financial markets led to a continued flight to quality in US Treasury Bond markets. The benchmark 10-year yield dropped 4 basis points to 4.52 percent, while the shorter-dated 2-year Note lost a whopping 9 bp to 4.11 percent. Given continued flight to quality, we may see further Yen strength and carry trade tumbles through the short term.

Written by David Rodriguez, Currency Analyst for DailyFX.com