More Carry Unwinding Is Still Possible

Currency markets will remain vulnerable to fears about further subprime woes, especially if US data later this week fail to convince investors that the Federal Reserve will cut interest rates. This means that despite some recovery in risk appetite a further unwinding of carry trades is possible, helping to push the yen higher against the euro and the dollar.

Both US President George Bush and US Federal Reserve Chairman Ben Bernanke helped to confirm that the status quo remains after both made it clear in speeches last Friday that policy won't be aimed at bailing out financial markets. Both provided reassurance that they will act to ensure that the US economy doesn't suffer from subprime spillover and this was enough to initially boost sentiment in US stocks. But after a weekend of reflection, analysts are taking the view that there has been little change to the interest rate outlook. "The better tone to equities has failed to carry through, leaving risk and carry foreign-exchange trades looking as vulnerable as they have done in recent weeks, even with much of speculative market positions squared and the option market long protection," said Lena Komileva, an economist for the Group of Seven leading industrial nations with international brokers Tullet Prebon in London. "While Bernanke left the rate cut door wide open, he didn't leave the impression of being ready to act ahead of the curve," said Hans Redeker, head of global foreign-exchange strategy at BNP Paribas in London. "Bernanke saying that the Fed would act as required by economic circumstances doesn't sound like somebody accepting financial markets as a leading indicator," Redeker added. Some reckon that even if Bernanke does deliver a 25-basis-point cut in rates at the next Federal Open Market Committee meeting Sept. 18, this still won't be enough to extract concerns about subprime. "The speech didn't give any hint as to the size of a September cut, but if Bernanke wants to restore confidence then he will be disappointing a lot of market investors if he only delivers a 25-basis-point cut. Markets moved following his speech to price in a slightly greater chance of a 50-point cut than previously," said Rob Carnell, chief international economist with ING Financial Markets in London. Central to the argument over the official response to the subprime problem is the issue of "moral hazard" and the reluctance of the authorities to be seen bailing out financial markets that have misjudged the risks they took. At the same time, however, Bush and Bernanke are anxious to ensure that the wider economy isn't affected by the subprime problem. The problem is that evidence of that spillover still remains pretty scarce. "We suspect that some evidence of broader economic 'damage' may first be needed if Mr. Bernanke et al are to chance their principles on the accountability of risk," said Neil Mellor, a senior currency strategist with Bank of New York in London. "Pressure upon the FOMC to act will certainly grow if economic data unveil any notable weakening in activity; and as such, this week's US data release schedule ...is likely to be one of the most important for some time," Mellor added.

Subprime Issues Will Remain Prominent

The two key economic numbers this week are the Institute of Supply Management's latest index for the manufacturing industry and the new non-farm payrolls. The former is expected to decline slightly to 53.0 from 53.8, according to the latest consensus forecast. The latter is seen rising to 120,000 from 92,000. Mitul Kotecha, chief currency strategist with Calyon Credit Agricole, also points to the Fed's reluctance to ease monetary policy while unemployment is still falling. "In the past, the Fed has been reluctant to cut interest rates unless the unemployment rate is trending higher, something that hasn't occurred yet," he said. "However, the growing emphasis on the negative economic impact of subprime problems suggests that the Fed won't wait for a significant increase in the unemployment rate before cutting rates." At the moment, general measures of risk appetite continue to show signs of recovery as they have over the last two weeks. This has encouraged a return to carry trades and pushed the yen back down against most other major currencies. Nevertheless, noted Kotecha, "the continued drip feed of bad news suggests that subprime issues will remain prominent, with risk aversion trades continuing to be favored." The continued jitters in financial markets, as they wait for the US to reopen later Tuesday after the Labor Day holiday Monday, were evident in another 0.6% loss on the Nikkei index in Japan and a continued decline in the euro against the yen. By 0645 GMT, the euro had slipped to Y157.83 from Y157.95 late Monday in New York, according to EBS. The dollar was flat at Y115.87, compared with Y115.84 as the euro fell to $1.3616 from $1.3627. The market is now focused on the new Institute of Supply Management survey for manufacturing industry. A steeper decline beyond the expected reading of 53.0 could raise expectations of a Fed rate cut.