Dow Rises 300 Points, Triggering a Turn in Carry Trades
The Dow has rallied more than 500 points over the past 2 trading days, triggering a sharp rebound in all of the Japanese Yen crosses. Carry trades are back with a vengeance, but the question at the forefront of everyone’s minds is whether this trend will continue. Without a doubt the move in the Dow is impressive, but USD/JPY is struggling to sustain its gains above 110 which suggests that further gains in carry trades may be limited. This is especially true since the move in both the Dow and carry trades have been fueled by nothing other than risk appetite and the latest US releases validate the market’s belief that Federal Reserve needs to continue lowering interest rates. The curve is pricing in a 92 percent chance for a 25bp rate cut next month followed by the possibility of another quarter point cut in the first quarter of 2008. The first test of whether the gains in carry trades can be sustained will be when Tokyo opens for trading tonight. Japanese industrial production and small business confidence are due for release this evening, but it should matter little to a market focused on risk appetite. Instead, keep an eye on China. Last night a Chinese newspaper suggested that the government could widen the trading band or make another one off revaluation. The odds are low, but unexpected events like these are exactly what triggers big moves in the currency market.

Dollar: Beige Book Report Validates Need for Further Easing
With the Federal Reserve at odds with market expectations, traders were banking on today’s Beige Book report to clear the air on who is more right about the outlook for the US economy. Recent Fed rhetoric has been all over the place with yesterday’s hawkish comments from Evans and Plosser offset by the dovish comments by Kohn today. The market, on other hand, has continued to price in a growing chance of a recession and even though we do not believe that a recession will occur, the US economy could come very close to it. This morning’s data indicates that weakness of the US dollar has done nothing to help the economy.  Durable goods fell for the third consecutive month while existing home sales plummeted to eight year lows. Even the Beige Book painted a grim outlook with the various Fed districts reporting slower growth, little change in manufacturing, modest price pressures, depressed real estate markets and a slow holiday shopping season. The only reason why US stocks and carry trades are higher is because the market expects the Federal Reserve to lower interest rates and they are pricing in the expected benefits. Third quarter GDP and New home sales are due for release tomorrow. The forecasts for GDP are very high, which means that it won’t take much to surprise to the downside.

Euro Sees Strong Intraday Reversal
Having fallen to a low of 1.4712 intraday, the reversal in the EUR/USD was nothing short of impressive. US and Eurozone economic data continued to surprise in opposite directions, leading us to believe that the currency pair still has a chance of testing 1.50. M3 which is an inflation measure came out slightly stronger than expected, Italian retailer confidence was also stronger and even though the German Gfk consumer confidence survey was softer, the revision to the prior month’s number puts it right in line with expectations. Tomorrow we are expecting another laundry list of economic data from the Eurozone including German unemployment, retail PMI and producer prices. Most of these reports should surprise to the upside as the strength of the Euro fails to put a meaningful dent on the Eurozone economy. Meanwhile in Switzerland, the KoF leading indicator was also much stronger than expected, but that did not prevent the Swiss franc from falling against the Euro as renewed risk appetite sweeps the currency pair higher.

British Pound Rallies on BoE Comments
The British pound rallied against both the US dollar and Euro thanks to the strong demand for high yielding currencies and hawkish comments from Bank of England policymaker Sentence. Although many people believe that a rate cut by the BoE is a done deal, Sentance’s comment that setting monetary policy in the months ahead will be a particularly challenging task suggests that the central bank has not made up its mind. Like his other counterparts, he was worried about the upside risk to inflation and the downside risk to growth. Unfortunately tomorrow’s data will not give traders any new information on where the greater pressure lies since the market has already discounted a further deterioration in the housing market and Nationwide house prices and mortgage approvals are expected to confirm that.

Australian, New Zealand and Canadian dollars Unfazed by Weaker Commodity Prices
The Australian, New Zealand and Canadian dollars are stronger across the board despite a drop in commodity prices. With no economic data released other than mixed Australian reports, the primary driver of commodity price strength is risk appetite. The breakouts in the Australian and New Zealand are impressive and judging from the price action, we could see further gains. USD/CAD however is still holding above Tuesday’s low which means that there is a decent chance for a bounce. We have a lot of important Canadian economic data due out over the next 48 hours. Tomorrow we are expecting the current account and raw material prices both of which are directly impacted by the level of the Canadian dollar. We expect these numbers to be weaker which could trigger the bounce in USD/CAD. New Zealand has money supply and business confidence due for release. Building permits dropped -4.3 percent, but the change from the prior month should not be significant enough to offset the strong retail sales and PPI numbers that we have seen in the past few weeks.

Kathy Lien is the Chief Currency Strategist at FXCM.