Will Carry Trades Follow in the Footsteps of the Dow?
Carry trades continued to rule the currency market as the New Zealand dollar and British Pound hit fresh 17 and 15 year highs against the Japanese Yen. The rallies began at the onset of European trading and even though the Dow Jones Industrial Average turned midday, carry trades continued to charge forward. The Bank of Japan’s nonchalant take on interest rate hikes has given traders a green light to keep loading up on yields. The minutes from the latest central bank meeting were released last night and all of the members agreed that interest rates should be raised gradually. The wording of this language indicates that even if the central bank were to raise rates by the end of the year, another hike beyond that will not be for another six months. So what is going on? The rise in US yields is helping to spur demand for USD/JPY but most likely, we think that today’s price action reflects a delayed reaction in the carry trades. Tonight we have the trade balance which could help lift the Japanese Yen, but the reversal in US stocks, as well as the rise in volatility and the meltdown in Latin American currencies such as the Mexican Peso suggests a turn. They could pose a big risk to carry trades because they tend to be a measure of global risk appetite. When we have markets collapsing and volatility rising, it will be difficult for carry trades to continue to rise. We are already seeing weakness after the 5pm triple rollover payment. Of course, if the Dow just snaps back, like it has been doing every time we see a triple digit drop, then the lifespan of carry trades will be extended. But the thin line that carry traders are walking down is becoming thinner in the
process.

US Dollar Mixed but Officials are More Concerned about Fallouts from Sub-Prime Collapse
With no major US economic data on the calendar today, it was another quiet day for the dollar. Higher yields is helping to lift the greenback against the Japanese Yen, Euro and Canadian dollar but the currency is softer against the New Zealand dollar, British pound and Swiss franc. Interestingly enough, the dollar is primarily stronger against the currency pairs that it has a yield advantage over. Looking ahead, our dull day will be coming to an end tomorrow when we have leading indicators and the Philly Fed due for release. The sharp jump in the Empire State survey as well as the overall rally in the stock market last month suggests that both numbers should be dollar positive. It seems that Federal Reserve officials are becoming concerned about the economy after Bear Sterns announced that 2 of its hedge funds were being shut down due to the big losses that the funds suffered on sub-prime bets. US Treasury Secretary Paulson warned this afternoon that there will be more losses stemming from the sub-prime collapse. Federal Reserve President Yellen also warned against becoming too complacent with risk in environments where fresh highs are becoming the norm. It looks like the central bank is trying to put a lid in the stock market rally, which is probably in everyone’s best interest in the long run since bubbles always pop.

Bank of England Minutes Puts 6.00 Percent in Target
Interest rate expectations are the number one driver of price action in the currency market, particularly when it comes as an unexpected announcement related to the future of rates. This morning, the minutes from the monetary policy meeting held earlier this month revealed that the policy making committee voted 5 to 4 to leave interest rates unchanged. After just having raised rates the prior month, nearly everyone expected a unanimous vote to leave interest rates at 5.50 percent. But instead, 4 of the members voted for another quarter point hike which means that the central bank is clearly taking the rise in inflationary pressures seriously. We are weary of being too optimistic about rate hikes given the recent drop in average wage growth. In the late US session, BoE Governor King warned that they still expect inflation to slow this year. This confidence may be linked to their plan for further rate hikes. We expect another 25bp of tightening in August and the possibility of 6 percent rates by the end of the year.

EUR/CHF Rally Ends after Jump in Swiss PPI
The Euro has become the perfect currency for those who like to trade ranges and the worst for those who like action. For the past month, the currency pair has remained contained within a 300 pip trading range. Economic data has been mixed, but comments from ECB officials suggest that the central bank is still on track to raise interest rates. German producer prices were stronger than expected in the month of May, but Italian industrial orders and Eurozone construction output were weaker. Interestingly enough, the bigger surprise in data and currency reaction was the Swiss Franc. Swiss producer prices jumped 0.9 percent in May, bringing the annualized pace of growth up from 2.6 percent to 2.8 percent. The market was actually looking for a slowdown in growth, so the surprise certainly brings inflation fears back to the forefront. This reinforces the Swiss National Bank’s need to raise interest rates again this year which should put a cap to the impressive rally in EUR/CHF. The currency pair hit a 9 year high yesterday.

Further Weakness in Commodity Currencies?
The Australian and Canadian dollars sold off on the back of softer gold and oil prices. A report that gasoline supplies in the US were stronger than expected put an end to the five day rally in crude. Canadian data was also weaker than expected. Even though leading indicators were stronger, wholesale sales dropped by 3.1 percent, which suggest that we could see weaker retail sales tomorrow. Australian data was actually stronger, with an increase in leading indicators. The New Zealand dollar was the only commodity currency to rally today and that has spurred rumors of potential intervention by the Reserve Bank of New Zealand tonight if the Kiwi does not weaken first on rising risk aversion.

Kathy Lien is the Chief Currency Strategist at FXCM.