The US dollar and Japanese yen were the weakest of the majors as investor confidence surged, driving up FX carry trades and sending the DJIA and S&P 500 up roughly 3 percent. For evidence that the dollar’s decline was driven by risk trends rather than fundamentals, one must only look to the US data on hand. First, the US consumer price index (CPI) rose more than anticipated at a rate of 0.7 percent in June, driven by energy prices, though the annual rate did fall to -1.4 percent, the lowest since January 1950, from -1.3 percent. Meanwhile, the Federal Reserve Bank of New York’s “Empire” manufacturing index jumped up to a 15-month high of -0.55 in July from -9.41, with a breakdown of the report showing a surge in prices paid, new orders, and shipments.
However, the release of the minutes from the Federal Reserve’s June meeting left the markets on edge, cutting rallies in FX carry trades short amidst changes to growth and inflation forecasts. Furthermore, central bankers generally expressed doubts that expanding their quantitative easing program would have much of an impact, indicating that traders should not expect increased Treasury purchases anytime soon. Taking a closer look at the Fed’s projections, inflation forecasts were revised slightly higher, suggesting that the central bank doesn’t anticipate deflation becoming an issue, while 2009 GDP projections were revised up to -1.5 percent to -1.0 percent from -2.0 percent to -1.3 percent, and the 2009 unemployment rate forecasts were changed to 9.8 percent to 10.1 percent from 9.2 percent to 9.6 percent.
In other news, trading of CIT Group, a large and troubled commercial lender, was halted this afternoon, suggesting that some sort of news will be released soon. This leaves the question open of whether they will they be deemed as being “too big to fail”, but the market’s response to the news may be negative either way. Indeed, a bailout would set a precedent that the US government will save anyone, which feeds moral hazard, while a bankruptcy filing by CIT would highlight the fact that financial market conditions remain unstable. There are other potentially ominous pieces of news that will be released through the end of the week: JPMorgan Chase will publish Q2 earnings on Thursday morning while Bank of America, Citigroup, and BB&T will publish theirs on Friday. Of the four banks, only Citigroup is expected to announce another quarter of losses, but following the astonishingly strong results we saw from Goldman Sachs on Tuesday, there’s a risk that the bar has been set too high and any disappointing result could resonate deeply with investors and spark flight-to-quality toward the US dollar and Japanese yen, while weighing on carry trades and stocks.