Forex Carry Trade Improves, Dollar to Continue Lower?

A modest carry trade rebound left the US dollar lower against higher-yielding forex counterparts, leaving scope for continued greenback declines through the coming week of trade. Indeed, a moderation in risk aversion was seen across financial asset classes; the closely-followed S&P 500 Volatility Index fell nearly 7 percent to 28.01. Markets seemed complacent with the drop in volatility seen on Friday?s US Federal Reserve interest rate cut, reversing some of last week?s extended moves.

The Euro and the Japanese Yen were the only major currencies to drop against the US dollar, with the single currency shedding $.0019 to $1.3469. Carry traders regained some ground through the afternoon, sending the greenback as much as ¥1.40 improved to highs of ¥115.49. A jump in demand for high-yielders likewise spread to the British Pound, which added as much as $.0094 before easing to $1.9838.
Fresh US economic data was limited to the morning?s Leading Economic Index report, which showed a modest pickup in economic activity through the month of July. The improvement was largely forecast, however, as it came on a drop in unemployment insurance claims through the period. Given that we have already seen Initial Jobless Claims higher through the early weeks of August, there remain questions as to whether July?s Leading Economic Indicator bounce remains relevant in terms of outlook for the US economy. Suffice to say, markets have grown increasingly pessimistic of growth prospects in the world?s largest economy.

Given an increasingly dovish US Federal Reserve, analysts feel that it is only a matter of time before dimming growth prospects force the FOMC to cut domestic interest rates. Indeed, the Fed itself claims that growth?and not inflation?remains the main policy concern going forward. This is a critical shift in its stance on the economy, and market interest rate curves have responded accordingly. The implied yield on the December Eurodollars contract shows expectations of up to 50 basis points in rate cuts through 2007. Subsequent implications for the US dollar are fairly obvious: the greenback stands to weaken on worsening interest rate differentials against major trading counterparts. Of course, the direction of the US dollar will likewise depend on a wide range of exogenous factors. One of the critical components for dollar strength remains the performance of global equity markets and broader risk across financial asset classes.
The US Dow Jones Industrial Average reversed earlier gains, leading to a modest dollar bounce at time of writing. Market participants sent the closely-followed index 73 points lower to 13,006.16, with seemingly little in the way of a break below the critical 13,000 mark. The S&P 500 was the worst percentage performer of the three, losing 13 points to 1,434. Meanwhile, the NASDAQ Composite traded 0.5 percent off to 2,491.
Risk aversion was most clearly seen in domestic fixed income markets, with US Treasury prices significantly higher on the day. The benchmark 10-Year Note added an impressive 17/32 points to 101 and 1/16. Yields were seven basis points worse to 4.61 percent?their lowest levels since March.