DB FX Daily: London Strong US Data Not Enough to Turn Rate Differential Trend in Favo

[RTFX-Trading]

FX Daily: London

Strong US Data Not Enough to Turn Rate Differential Trend in Favour of USD (yet)

Despite the strong US labour report at the end of last week, the dollar has broadly returned to the level it was trading at before the data release. Indeed, one of the key drivers of the dollar (at least versus euro), the 2-year rate differential, has not convincingly turned in favour of the dollar (see first chart). Inflation risks, though, appear to have subsided at least according to the US yield curve and implied inflation expectations from the TIPS market. Therefore, the macro backdrop for the dollar has turned somewhat more positive of late. This week's speeches by Fed officials (and FOMC minutes), coupled with an ECB meeting, will bring the attention back to central banks, and this could provide the cue for the next major move in the dollar. In the meantime, we prefer to stay on the sidelines for the dollar.

Keep an Eye on Volatility for G10 Carry

G10 FX carry trades have continued to perform well in recent days. High-yielders, such as the AUD, have reached new highs, while many of the low-yielders have been falling. Indeed, crosses such as EUR/JPY and EUR/CHF have touched highs for 2007 in recent days. The triggers for the end-February /early March carry unwind, such as turmoil in other markets or a BoJ hike, appear unlikely to emerge in the short-run. Perhaps more importantly, the fact that volatility has yet to return to the pre-unwind levels, though it has been falling, suggests that the market is still fearful of an unwind (see second chart). A key signal for the next round of unwinds would be complacency, so the level of volatility may prove be to a useful marker for that. Indeed, we continue to recommend staying out of G10 carry trades as we believe valuation concerns will lead to more unwinds over the course of 2007.