FX Update: Carry trade train-wreck now upon us

FX Update: Carry trade train-wreck now upon us

Today is seeing an acceleration in the carry trade meltdown, which is now turning into an absolute train wreck as the price action in crosses like AUDUSD and especially AUDJPY turns increasingly parabolic in nature. As we have discussed before, once price action goes parabolic, the time horizon for "finding the bottom" is usually very short - often a matter of a few days or less, while the price horizon during parabolic price action can end almost anywhere. So the bottom may come/have come today or not until Friday/Monday. If equities are unable to hold the 200-day moving average in the S&P500 today or in the coming couple of days, we can't rule out 0.7500 in AUDUSD or even 65 in AUDJPY (trading at 0.8400 and 77.00 today, respectively). The scary thing for both sides of the trade is that once the sell-off ends, the initial bounce can be equally or even more volatile as the market seeks out equilibrium, so both bears and bulls need to tread carefully here and respect the volatility potential.

The key trigger for today's risk aversion was Germany's announcement that it would ban naked short selling of CDS, EUR denominated debt and stocks of key financial institutions as this smacked of desperation and as such measures in the past have ended in uncomfortable contractions in liquidity that only serve to aggravate risk appetite even more so than a hands off approach might. Stress levels in the European money markets are moving higher again on this action - near recent highs, in fact, and US money market related risk spreads have also widened recently. After an initial and sizeable swoon on announcing the measures, however, the majority of the pressure in FX is being felt by emerging market and commodity currencies as a sign of the more traditional risk off behavior in FX land. EURAUD is as much as 400 pips higher in today's trade. The latter development shows that we are seeing AUD longs getting desperate while there may be little additional room in the short term for more EUR shorting in positioning terms. If this move in risk unwinding extends further, the EUR may begin to perform even better relative to the rest of the market, due to its deeper liquidity and, again, on the potential for exhaustion of new shorts.

Chart: EURAUD

We've been looking at this trade for some time, as we felt that the risk for downside in the Aussie is far greater than that for the Euro in a cycle of risk aversion. This is finally strongly evident in the last few days of trading, as the pair has marched from sub-1.40 levels recently to 1.45 in today's trade. Even if risk appetite recovers, however, the pair might continue to carve out a bottom.

Keep an eye on US lawmakers
The US Senate voted recently to oppose the IMF lending money to countries taht are not likely to repay the debt, but that vote was swallowed in a larger vote on new financial reforms and may not make it into the final version of the financial reform bill. The financial reform bill under discussion in both house of the US congress will bear close watching, due to its potential impact on banks large and small and on the critical credit market a strong impact on the market. The question now is what form the final version of the bill will take, which is not at all certain at this point. Ironies abound with this bill, including the idea that the many proposed "consumer protection" measures will make it much harder for banks to extend credit in the first place, such that higher risk borrowers may completely lose access to the mark.

The other two very big issues in the bill are new restrictions on banks' activities (especially on the contentious prop-trading issue and on whether banks can be commercial banks and investment banks simultaneously, as was not allowed until Glass-Steagall was repealed in 1999). Finally, wide-sweeping proposals about derivatives trading is another massive issue, though Senator Dodd is out trying to put a two-year moratorium on derivatives reform so that it can first be "studied". Any hasty move to put derivative on exchanges and requiring holders of derivatives to post collateral on their trades would result in immediate and total chaos. The uncertainty around this bill is another reason for nervousness in risk here.

Chart: USDJPY
USDJPY testing key support levels today as bond markets rallied yet again, but as bond markets eased off, the pair slipped back above the key support level at 91.45, which is the Ichimoku cloud level on the daily chart. This is an important level to watch to see if the pair can find support or if it risks a capitulation lower in the even of further pressure from risk aversion.The 200-day moving average (dotted red line) is also in play.

UK inflation outlook
The latest UK inflation reading came out higher than expected again yesterday, but since the BoE declared it is willing to look through high inflation levels in the short term, it is hard to get exceptionally bullish on the readings until the BoE decides they are important as well. Short sterling STIRs actually traded higher in today's trade. Today's BoE minutes showed that the MPC is divided on whether it should be fretting the current, high inflation levels. Some are more concerned about the EuroZone situation and constraints on credit while others can't understand why inflation is this high when capacity utilization is so low. King wrote in a letter to the new government that "the pace and extent of the prospective fall in inflation are highly uncertain." Indeed. Should King simply have written: Chancellor Osborne, we've no clue what will happen? 

US data
It's interesting to note that relative strong US figures of late, as the May NAHB on Monday was the strongest reading since 2007 despite the expiration of the house purchase tax incentive. April housing starts were also very strong and last night's weekly confidence ticked strongly higher. While the market is distracted with the EuroZone stability and the financial reform bill, we are seeing some strong numbers in the US, certainly a development worth tracking. For the rest of the week, the only data points of (marginal) interest in the US are the weekly jobless claims and Philly Fed numbers up tomorrow. Meanwhile, today's year-on-year US core inflation data shows the lowest inflation since the mid-1960's.

In the meantime, we watch for signs of whether the risk situation is worsening (which it is doing until further notice) and when it can stabilize. The latter will likely happen relatively soon, at least for a time, but again, from what level?

Looking ahead
Much of the above was written as risk aversion was very high on the day. Ahead of the US open, we are seeing quite a squeeze from the bulls - with no readily apparent catalyst other than rumors of an ECB announcement, to which the ECB has replied "no comment" rather than saying that no statement will be forthcoming. Hmm... Stay on your toes everyone. A Euro squeeze is certainly a huge risk in the nearest term that the market is ill prepared for.

Stay extra careful out there.

Economic Data Highlights

• USA Weekly ABC Consumer Confidence out at -44 vs. -47 expected
• Australia Q1 Wage Cost Index rose +0.9% QoQ vs. +0.8% expected
• EuroZone Mar. Construction Output rose +7.6% MoM, but fell -5.2% YoY vs. -15.2% YoY in Feb.
• Canada Mar. Wholesale Sales out at +1.4% MoM vs. +0.6% expected
  US Apr. Consumer Price Index out at -0.1% MoM and +2.2% YoY vs. +0.1/+2.4% expected, respectively
• US Apr. CPI ex Food and Energy out at 0.0% MoM and +0.9% YoY vs. +0.1/+1.0% expected, respectively

Upcoming Economic Calendar Highlights

• US Q1 Mortgage Delinquencies (1400)
• US Weekly DOE Crude Oil and Product Inventories (1430)
• US FOMC Meeting Minutes (1800)
• Japan Q1 Housing Loans (2350)
• Japan Q1 GDP Estimate (2350)