The prospects for the global economy continue to deteriorate and in response we are seeing a partial liquidation in carry trade positions.

Carry trade is when financial institutions, as well as some retail traders, try to buy a higher yielding currencies like the Australian dollar - with a benchmark interest-rate at 4.75% - by selling, or funding that carry trade position, with a low yielding currencies such as the Japanese yen or US dollar. In essence you are borrowing at the low interest-rate and parking that money in the higher-yielding asset and try and earn the difference between the interest between them.

We had a period of carry trade liquidation in the beginning of August as a result of the downgrade of the US credit rating by S&P, as well as the weakening fundamental picture from a macro sense from both the euro zone and the US.

Perhaps the market was anticipating some type of rescue from the Federal Reserve, and the fact that the Fed painted a gloomier outlook for the economy now increases the chances of the US sliding back into recession in the eyes of traders and investors. That would have spillover effects for the rest of the global economy and is likely to hurt global trade.

It's the prospect of low or no-growth scenario that is driving the sell-off, and not so much the Fed's decision.

Macro Data from China and Euro-zone Worry Investors

Data overnight showed us that the Chinese manufacturing base is slowing - the third month in a row that the HSBC manufacturing PMI has been below the 50 level.

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While this may not mean a hard landing for China, export orders contracted further, which is what an economy like Australia should be concerned about.

On top of that, we see the flash reading for euro zone services and manufacturing in Europe showing contraction and concerns about Dollar funding for European institutions battering the EUR despite some progress in Greek talks with the EU/IMF.

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As we can see here, GDP follows the PMI composite index quite well, and if so, it's pointing toward negative growth in the 3rd quarter, a bad sign for the prospect of global growth, and for the EUR.

If ECB Moves to Lower Rates, EUR Will Continue to Feel the Pressure

For the euro, the recent data will not only keep the ECB from hiking rates, but may now also cause the ECB to lower rates in order to help stimulate an economy that is faltering. This can be done if the ECB sees inflation expectations weakening and incorporate that into their forecast. Any indication that the ECB may be considering lowering rates would be a euro negative and is likely one of the underlying reasons the euro has tumbled through the 1.35 area in this week's trading.

The concerns are squarely on European banks as well as the IMF put out a report saying that the European debt crisis has generated as much as $410 billion in credit risk fore European banks.

RBA Has Room to Drop Rates if Global Recovery Deteriorates

If the prognosis of a weaker global recovery comes true than the RBA would also be in a position to cut interest rates in order to help stimulate its economy. Right now the RBA is in a wait-and-see mode, and has try to be beat back expectations of an interest rate cut in its recent statement.

If the RBA moves in that direction, we would have a shift in bias to the downside for the Aussie. So far it has been risk-on/risk-off sentiment driving AUD/USD, but we may now be incorporating the possibility of lower rates which hurt the Aussie from the fundamental side of things.

For a technical analysis look at AUD/USD:  AUD/USD Reverses Long-term Trend Overnight; 0.97, 0.9400 in Sight

Nick Nasad
Chief Market Analyst
FXTimes