The carry trade continued to unwind today as USD/JPY broke the 114.00 figure for the for first time in nearly three months. The market appears to be certain that 2006 will augur the abandonment of Zero Rate Interest Policy, but have our doubts.  Aside from very strong institutional opposition to any monetary policy changes from the ruling LDP party, there is still very little evidence that Japan has conclusively conquered its decade long fight with deflation. For starters, this week's Household Spending numbers were woeful printing yet another negative month over month comparison and making mince meat out of the yen bull' s thesis that consumer spending has finally recovered. Today's Bank Lending figures only serve to confirm the fact the country remains far from a balanced recovery as the numbers actually contracted by -0.1% versus expectations of 1.0% gain. To be certain, the lower yen has fueled an export boom in Japan which should eventually translate into healthier domestic demand, but that process may take much longer than the market realizes.

On the flip side of the pair, currency traders have been anticipating an almost immediate end of the Fed rate hike cycle. Here too expectations may be running ahead of reality. The key factor in dollar bears argument for a marked slowdown is the imminent housing bubble burst. Yet yesterday's MBA mortgage figures showed a 9.9% week on week increase in activity.  The numbers had to be heavily adjusted for holiday fluctuations, but regardless of their accuracy anecdotal data from real estate brokers suggests that activity did return with the new year. If the housing bubble does not burst, but instead goes into a slow fizzle US short rates may reach 5% before topping out. In that case the rumors of the death of the carry may be highly exaggerated and USD/JPY may yet have another up leg left.  Positioning has been the one factor that's been supportive for yen bulls, Our proprietary SSI index continues to show that spec traders have been continuously trying to catch the bottom of this move with more than 2 dollar longs for every yen long. Until the ratio flips, any bounce in USD/JPY will be contained, but the turn may be coming sooner than most traders think.

Boris Schlossberg is a Senior Currency Strategist at FXCM.