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Yen Rallies As Risk Aversion Grips Market

Wednesday, January 23, 2008

NEW YORK (Dow Jones)--Risk aversion has gripped currency markets early Wednesday in New York, with the yen rallying against the dollar and euro.

The Federal Reserve's emergency inter-meeting interest rate cut Tuesday afforded only limited relief to markets, and they are back in risk-averse mode. The dollar recently reached a fresh two-and-a-half year low versus the yen at Y104.95. The euro also fell to Y152.79 - not as low as before the rate cut Tuesday, in the wake of the frenzy in global equities a day earlier on fears of a U.S. recession.

The higher-yielding currencies, such as the euro, are suffering at the hands of the lower-yielding yen and dollar due to the unwind of riskier carry trade positions, wherein investors borrow lower-yielding currencies to fund bets in riskier assets - what's known as the "carry trade."

The rate cut "isn't going to forestall further adjustments to currency markets," with a resumption of equity market weakness and yields plunging, said John McCarthy, manager of currency trading at ING Capital Markets in New York.

"Those trades that have been big money makers this year, and that includes the carry trade, traders are liquidating to make up for losses in other investments" that have been hurt by developments in the U.S., said McCarthy.

Gains in the yen and Swiss franc are more pronounced versus the euro than the dollar because markets are convinced the euro zone won't escape the U.S.'s economic weakness unscathed, noted Robert Lynch, currency strategist at HSBC in New York, citing a number of reasons.

In addition, analysts expect increased downside risks to European growth, evidenced in data out Wednesday, and that financial institutions outside the U.S. will bear the same problems as their peers, said Lynch. Indeed, Euribor yields have plunged.

The euro is also falling to weakness against the dollar as a result of pressure from its other crosses, like the yen, he said. It recently fell to a new intraday low of $1.4510.

Early Wednesday in New York, the euro was at $1.4515 from $1.4618 late Tuesday, while the dollar was at Y105.26 from Y106.66. The euro was at Y152.90 from Y155.89. The U.K. pound was at $1.9478 from $1.9586, according to UBS. The dollar was quoted at CHF1.0905 from CHF1.0984 late Tuesday.

Global equities continue to show weakness, leading analysts to conclude that the Fed will need to cut rates again at its next meeting Jan. 29-30.

On Tuesday, the Fed slashed the target for its key federal funds rate by a full 75 basis points to 3.50%.

In a speech overnight, the European Central Bank President Jean-Claude Trichet did not suggest that the euro zone is heading in the same direction as the U.S.

There is no plan to alter the ECB's baseline economic scenario despite recent developments, Trichet said. Yet, data Wednesday showed that economic activity in the euro zone continues to weaken.

The latest flash estimate of the purchasing managers' index for manufacturing held steady at 52.6, but the one for services dropped sharply to 52.0 from 53.3. This was the lowest since August 2003.

"G7 decoupling will prove elusive. We think the ECB will have to follow the Fed sooner rather than later. The longer the ECB hesitates, the worse the outlook for the euro will become," wrote UBS currency analyst Benedikt Germanier in a research note. UBS expects the euro to trade back toward $1.43, and is short from $1.4510 as a trade recommendation, targeting $1.4200.

Elsewhere, the deteriorating state of the U.K. public finances was highlighted by the European Commission in a regular assessment of European Union member states' adherence to budgetary rules Wednesday. The Commission urged the U.K. government to "substantially improve" its budget position.

The Bank of England's Monetary Policy Committee on Wednesday released minutes from its last meeting. One member dissented from keeping the repo rate on hold in January, voting instead to cut the policy rate 25 basis points. The majority of members noted that the short-term inflation outlook had "worsened markedly," and found that an immediate cut in rates wasn't necessary, following December's reduction - the first since August 2005.

The tone of the minutes suggests that a reduction in rates at the bank's February policy meeting is still on the cards. But the emphasis on upside inflationary risks indicates that the BOE is likely to take a cautious approach to policy easing ahead.

Posted by MOHAMED SAID at 6:39 AM  

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