US Dollar: Is Risk Aversion Behind the Latest Move?
Softer economic data weighed on the US dollar today but the shallowness of the decline is a testament to the market’s overall demand for risk as well as its tolerance for US dollars. The combination of another weaker housing market report, lower consumer confidence and warnings that the problems in the sub-prime sector could spill over to prime should have set off alarms for all carry traders and dollar bulls. However, instead of dropping, the US dollar actually recovered over half of its losses against the Japanese Yen after the housing market numbers. In addition, the dollar held steady against the Euro and British while gold prices hit a 3 month low. If the market was truly becoming more risk averse because of the housing market issues, then gold prices would rise and not fall because investors tend to flock to the safety of gold whenever they are risk averse. Profit taking ahead of the Federal Reserve meeting has been blamed for the divergent market behavior as bond yields continued to rise. This suggests that the market still expects the Federal Reserve to remain hawkish despite the problems in housing. The main reason the Federal Reserve will choose to do so is inflation. The national average of gasoline prices are back below $3 a gallon but the cost of milk, butter and corn are all up sharply. This has forced companies like Domino’s Pizza, Starbucks and Wendy’s to either report a shortfall in profits or plans to increase prices. These changes will eventually hit core prices, which is one of the Federal Reserve’s primary inflation gauges. Therefore as long as we do not see a company like Washington Mutual take a big write-down in prime loans over the next 2 days, further dollar weakness ahead of the Fed rate decision should be limited. More important than the problems in housing, which have been with us for some time is the outlook for consumer spending. Consumer confidence sank to a 10 month low in the month of June. Weaker confidence is not likely to bode well for spending in the months to come.

Is It Carry Trade Liquidation or Profit Taking?
Carry trade liquidation has been blamed for the weakness in the Yen crosses today, but are the moves really carry trade liquidation or simply profit taking? Sharp intraday reversals in USD/JPY, EUR/JPY, CHF/JPY and GBP/JPY suggest the latter. The stock market has been flipping between positive and negative territory over the past two days, which is indicative of strong two way pressure on equities. So far, the move in the yen crosses fall far short of being labeled a liquidation, we need to see at least a one percent move in all of the currency pairs before becoming worried. Comments from Japanese officials suggest that they may be facing increased pressure from overseas authorities to stem the slide in the Yen. Now that yen weakness has taken off against the US dollar as well, the Japanese may be feeling the pressure from Washington. Finance Minister Omi said overnight that they are “monitoring the FX markets closely” and that the market should be “aware of the risks of one-way bets.” Over the next few days, we have a tremendous amount of Japanese data due for release including retail sales, industrial production, consumer prices, and the jobless rate. The corporate service price index hit a nine year high in the month of May, which suggests that consumer prices could be firm as well. Before getting too excited, retail sales are up first. Wage growth has been weak so the market is expecting another month of restrained spending in Japan.

Euro Stuck in a Range; Swiss Franc in Play
The Euro has been stuck in a 30 pip range throughout the US session trading session. We are finally seeing the impact of the strong Euro on economic activity. During the month of April, the Euro rose from 1.3350 to 1.3682 with virtually no retracements. Unsurprisingly, the current account surplus for that month turned into a deficit. French business confidence is the only piece of noteworthy data on the Eurozone calendar tomorrow and even that is normally not market moving. The bigger story is in Switzerland. The UBS consumption index dropped from 2.384 to 2.089 in the month of May, which was its first drop in six months. Despite the drop, the index still remains high which do not write off the possibility of a stronger KoF leading indicator report tomorrow. Economic activity overall has been robust and should continue to be thanks to the weakness of the Swiss Franc.

British Pound Trades Quietly ahead of Blair to Brown Changeover
Like the Euro, the British pound remained range bound throughout the US trading session. The 2.0 level is proving to be a serious point of contention as the GBP/USD fails to close above that price level for the second consecutive day. There was no UK economic data released overnight, but tomorrow will be a big day. After 10 years of service, Tony Blair will be stepping down as Prime Minister of the UK and will passing the baton over to Gordon Brown. For more details on what this means for the British pound, see our special report on Blair’s resignation. Mortgage approvals and the CBI Distributive Trades survey are also due for release; improvements are expected in both.

Australian Dollar Hits 18-Year Highs before Succumbing to the Weight of Gold
The Australian dollar was the only commodity currency to slip against the US dollar today. Although the biggest drop in new home sales in almost a year could be blamed, it was not the trigger for the day’s weakness. In fact, the AUD/USD hit an 18 year high before reversing all of its gains at the US market open. Instead, gold prices were to blame. Prices of the yellow metal fell to a 3 month low, dragging the Aussie dollar down with it. The New Zealand and Canadian dollars remained firm however. Demand for the high yielding New Zealand dollar has been unabated, but tonight’s trade balance data could mark a top in the currency pair. Despite the lack of Canadian data and the fall in oil prices, the currency pair benefited from the final approval of the Norwegian based Statoil takeover of Canadian based NAOSC for 2.2 billion Canadian dollars.

Kathy Lien is the Chief Currency Strategist at FXCM.