USD/JPY continued to hover stubbornly around the 118.00 level despite the better than expected Japanese economic data and a drop in crude below the $58 handle. Tonight's news revealed a larger than expected gain in GDP from 1.1% projected to 1.7% while Industrial Production picked up to 1.2% from 1.0%. The yen however remained trapped near two year lows against the dollar as speculative demand from momentum and carry traders kept USD/JPY well bid.  Next week several up coming events may be yen positive, not the least of which is the meeting between President Bush and Chinese President Hu Jintao during which Mr. Bush is expected to press his counterpart for additional revaluation in the yuan. Up to now all efforts to persuade China to further revalue the currency have failed, but many analysts feel that China will make another politically accommodative gesture to quell the rising protectionist rhetoric coming from US especially in light of the record Trade deficit recorded yesterday. If oil maintains its downward trajectory and if China does hint at revaluation of the yuan, then the long suffering yen bulls may actually see a rally. However, the focus of the market remains on the interest rate differentials and until such time that traders begin to sense the end of the carry trade, USD/JPY is unlikely to retrace materially.

Regarding the Trade deficit, the number was woefully large and though some market players shrugged off its implications due to one-off effects of Katrina, the underlying trend is clearly unsustainable.  The EUR/USD initially spiked higher but was brought down on the news that the new CDU/SPD government will enact a 3% raise in the VAT to further balance Germany's budget. It is more than ironic that markets have decided to reward the dollar for engaging in  the most profligate fiscal spending policy in the history of the country ( the present Administration has amassed more foreign debt than all other prior US governments combined)  while punishing the euro for attempts at fiscal responsibility. Nevertheless, the   current bet in the currency market is that US growth will trump all and further yield expansion will attract more capital to the dollar.  While we are hardly euro bulls at the moment we caution that the dollar is never more dangerous to the longs as when it looks to be the most invincible.

Boris Schlossberg is a Senior Currency Strategist at FXCM.