By DailyFX – The problems in the US housing market are worsening and anyone who is long stocks, carry trades… … or the US dollar is feeling the pain.

Next to the 3.2 percent decline in the Dow back in February, this is the largest
one day point loss since the beginning of the year. Unlike the previous
corrections that we had in June, there were plenty of clues that this
one could be a lot worse. In yesterdays Daily Fundamentals we talked
about how even though the stock market recovered, yields were lower,
which suggests that there may be more bad news to come. On Tuesday, we
warned that risk aversion is returning, which meant that the sell-off in
the yen crosses may be closer to liquidation than the profit taking that
we have seen in the past. We were watching the Chicago Board Options
Exchange Volatility Index or the VIX. At the time it was nearing
February levels and today, it hit a new 13 month high. High VIX
readings represent a rise in risk aversion and typically coincides with
a sharp sell-off in US stocks. We can also tell that risk aversion has
returned because credit spreads have widened significantly. The latest
wave of panic selling has been caused by the combination of weak US
economic data and news that Wells Fargo, the nations second largest
home lender and fifth largest bank will stop making sub prime loans
through third party brokers. We are clearly seeing the problems in the
housing market extend beyond subprime. New home sales dropped 6.6
percent in the month of June while rising inventories drove the median
price down 2.2 percent. Durable goods sales also fell short of
expectation as defense spending slowed. The labor market may even be
affected with newspaper help-wanted ads dipping to a 49 year low last
month. The fact that jobless claims remains at healthy levels indicates
that companies are not firing, but at the same time, it does not mean
that they are hiring. In light of all of this weak data, Fed fund
futures are now pricing in a 90 percent chance of a rate cut by the end
of the year; this represents a sharp jump from the 44 percent chance
reported yesterday. Given all of the disappointments reported today,
there is a decent chance that tomorrow’s second quarter GDP growth
figure will miss expectations. Even though the stock market has
rebounded, yields are still sharply lower which suggests that dollar
weakness may not be over.

Dow Plummets 300 Points, Carry Trade Liquidation Continues

Rising risk aversion has caused a wave of carry trade liquidation.
None of the Yen crosses were spared in the second worst day for carry
traders this year. The biggest losers were NZD/JPY and AUD/JPY, which
dropped 400 and 340 points respectively. Carry trades only work in a
market that is willing to take on risk. With evidence that things could
get worse before they get better in the US, it may be wise for carry
traders to stand aside for the time being. Some economists are once
again calling for a recession. Market expectations have shifted
dramatically which makes it a far more unstable environment than a few
months ago. Tonights Japanese data is not likely to matter at this
point because the problems are far more severe than the risk of a rate
hike by Japan. Consumer prices and retail sales are due for release.
Inflation is expected to remain nonexistent while retail sales are
predicted to rebound. A rebound in the Yen crosses will however be
contingent upon whether we see any follow through selling in the US
stock market.

Commodity Currencies Suffer as High Yielders Go Out of Favor

As victims of carry trade liquidation, the Australian, New Zealand and
Canadian dollars also sold off aggressively today. Unsurprisingly, the
biggest mover was the New Zealand dollar which suffered greatly from
last nights dovish comments by Reserve Bank of New Zealand Governor
Bollard. The trade balance is due for release tonight. The strong kiwi
is expected to turn the surplus into a deficit, which could exacerbate
the currencys weakness. The New Zealand dollar should also begin to
under perform its Australian counterpart as the recent inflation data
from Australia has the market pricing in another rate hike this year. A
turn is in place for all three currency pairs. We continue to expect
more weakness in the Canadian dollar, particularly against the Japanese
Yen.

Euro Rebounds on Broad Dollar Weakness; Swiss KoF Expected to be
Strong

On a day with big moves in all of the financial markets, the EUR/USD
was left out of the action. The meager 0.14 percent or 20 pip rally in
the currency pair suggests that even though traders are bearish dollars,
they are not all that bullish Euros either. Business sentiment in
Germany is deteriorating with the IFO survey dropping from 107 to 106.4
in July. This past week, we have seen plenty of evidence that the
strong Euro is having a negative impact on the Eurozone economy.
However for the time being, the negative impact has not become
severe enough to keep ECB members from enjoying their month long
holidays. The rise in money supply indicates that inflation is still a
problem, which means that the central bank can use a strong Euro to
reduce inflationary pressures. Meanwhile Switzerland will be releasing
its leading indicators report tomorrow. The economy has performed well
over the past month thanks to the weakness of the Swiss franc. We
expect the release to continue to reflect the country’s solid growth
prospects.

Weak Housing Numbers Weight on British Pound

The British pound sold off for the second day in a row on the back of
weak housing market data. Nationwide house prices increased only 0.1
percent in the month of July, dragging the annualized pace of price
growth down to 9.9 percent from 11.1 percent. The Chief Economist at
Nationwide blames the increase in house prices, but even so, traders
should not lose sight of the fact that the UK economy is out performing
the US economy. What is really weighing on the pound is GBP/JPY
liquidation. When that comes to an end, so could GBP selling.

DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com

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