The IFO survey of business sentiment declined sharply in June from 108.4 expected to 107.00. This was the lowest reading since November of 2006 and reflects the fact that German businesses are being hampered by unfavorable exchange rates and rising energy prices. Sentiment deteriorated across all sectors with Retail Trade seeing the largest drop in percentage terms from -3.2 to -5.0. EURUSD however was unaffected by the news as the IFO reading still represents relatively robust levels of business activity.

The euro was further boosted by the release of the Industrial New Orders data an hour later. The market had expected a month over month drop of -1.0% while the actual print was a far better -0.4% decline. Furthermore year over year gains reached double digits jumping by 12.2% versus 9.0% forecast. Therefore, despite the moderation in business sentiment, actual economic results continue to show healthy growth in Euro-zone’s vital industrial sector reassuring traders that more rates hike from the ECB are on their way.

Order flow in the FX market continues to gravitate towards those currencies with the highest possibility of immediate rate hikes. Thus the euro, the pound and the Aussie all performed well tonight with Aussie hitting 18 year highs against the greenback and rising above the 105 level against the yen. The yen remains the weakest link amongst the majors slumping to 124.00 against the dollar. At this point USDJPY appears to be destined to test the 125.00 figure – a level it hasn’t seen since December of 2002. However, if does hit 125.00 the pair is likely to encounter quite serious resistance at that mark – both for psychological and political reasons. We doubt that policymakers both in Europe and US will sit idly by as their respective industrial sectors experience progressively adverse completive conditions against their Japanese counterparts who are being aided by massive de facto currency devaluation.

The carry trade has been driven by the insatiable demand from yield hungry Japanese investors and certainly the recent lackluster Japanese economic results have done nothing to disprove the notion that Japanese rates will continue to remain stationary at 50bp for the time being. However, the carry trade is also highly sensitive to risk aversion. While volatility in FX has been extremely low supporting the carry trade over the past few months, those conditions could change instantly if the present problems in the CDO market worsen precipitating an avalanche of margin calls. For now the Bear Stearns story may move off the front pages, but we doubt that the risk of fallout has been truly contained. Finally, recent media stories of Japanese housewives beating Wall Street traders at the carry trade are almost always indicative of an end of a trend rather than the beginning and typically result in tears for retail investors. Thus, while fading the carry has been a mugs game all year long, joining it at this point may be unwise as well.

Boris Schlossberg is a Senior Currency Strategist at FXCM.