Markets Recovering but Risk Still the Dominant Factor

Traders and investors in financial markets around the world are preoccupied with paring back their risk exposure.  Internationally, emerging market investments are being cut back.  In the US equities market, stocks are losing attractiveness in favor of safer Treasury bonds.  With regard to the foreign exchange market, traders are shunning the risky carry trade.  The ultimate consequences of all this activity are strong support for the US dollar and the Japanese yen and a decline in the other major currencies.

The greenback’s rise is interesting.  With America at the locus of the subprime crisis, its currency is also the greatest beneficiary.  When risk rules the market, traders park their money in dollars, and that is likely to continue for some time.  EUR/USD acts as a proxy in the FX market for dollar sentiment, and the euro is on track to take a beating.  Economic data from the continent has also disappointed, while US Retail Sales surprised to the upside.  Unless the Fed surprises everyone with an immediate interest rate cut, dollar bulls should continue to smile.

The Japanese yen has been the other recipient of good fortune during this subprime mess.  All of the high yielders have taken turns falling against the yen.  Technical analysis points to now being the turning point for GBP/JPY.  But while the carry trade unwind is driving this growth in the yen, economic data in Japan is not supporting the rebound.  And so a long-term outlook in the currency cannot be positive.  The Bank of Japan does not have a basis to raise interest rates, and the yen will suffer accordingly.

Central banks are the major players in the FX market in this current environment.  Will the increased liquidity ease credit concerns?  Many analysts predict that the banks will be forced to concede inflation and lower rates to stave off a world-wide recession.  But predictions of this hard landing are wrong.  The market correction should even itself out, and the increase of money in the market should keep buying and selling going.