Japanese Yen Makes A Comeback Amidst Return To Risk Aversion
The Japanese yen made substantial gains today as a bout of risk aversion permeated throughout the forex, bond, and equity markets. News that the S&P may cut ratings on $12 billion worth of subprime mortgage-backed bonds sent traders flocking to safer havens, as USDJPY and NZDJPY plunged over 100 points towards 122.00 and 95.00, respectively. With interest rates in Japan still at an ultra-low 0.50 percent, today’s price action signals that a rate hike by the Bank of Japan may not necessarily be needed in order to initiate a massive unwinding of carry trades and confirming the dangers associated with maintaining highly leveraged trades. Such one way bets will also encounter event risk this week as the BOJ is scheduled to meet on Thursday. The central bank is widely expected to leave rates steady this month, especially as the economy remains in deflation and with the LDP elections occurring at the end of the month. So does this mean BOJ Governor Fukui will move to normalize rates in August? There is certainly speculation that he and his fellow policy makers will discuss such a move, but they will face substantial resistance from the government, as officials such as Kozo Yamamoto and Shigeyuki Goto have recently spoken out against such measures.

Canadian Dollar Plummets Despite Hike – What Happened?
As was widely expected, the Canadian overnight borrowing rate was increased 25 basis points to 4.50 percent. After the Bank of Canada left rates steady in May and said, "there is an increased risk that future inflation will persist above the 2 percent inflation target and that some increase in the target for the overnight rate may be required in the near term,” markets immediately started pricing in (correctly) a hike for today. Looking at this month’s policy statement, the Bank of Canada was a bit less hawkish than expected, which led the Canadian dollar to plummet across the board. Upon first glance, the statement appears relatively bullish for the Loonie, as it said that "some modest further increase" in rates may be needed while also noting that growth and inflation have been stronger than forecast. Nevertheless, with higher interest rates and the appreciation of the Canadian dollar anticipated to "moderate" growth, another round of policy tightening is very unlikely in the near term. The Australian dollar and New Zealand dollar fared much better today, with Aussie conquering the 0.8600 level while Kiwi made a test of 0.7800. Australian data proved bullish for the national currency, with Investment Lending surging 8.9 percent in May from 0.7 percent as NAB Business Confidence maintained a two year high of 15. New Zealand data, on the other hand, was dismal with the NZIER business confidence survey falling to -37 in the second quarter from -15 the quarter prior. Nevertheless, Kiwi will likely remain relatively supported by an expected rebound in retail sales on Thursday.

Is Subprime The Trigger For The Dollar?
Although already mentioned in the press and in trading rooms in recent months, it seems that subprime may be dealing a bigger blow than expected. The US dollar bore the brunt of the force today as it was announced that Standard & Poor’s, the credit rating agency, may be cutting credit ratings on almost $12 billion on bonds backed by subprime mortgages. The news sparked a market wide dumping of securities as concerns that the rating cut will have wider and bigger implications for US and global markets. And it will. With these rates cuts coming into the market, credit officers in every corner of the business will have to re-evaluate these assets, possibly enveloping the whole gamut of CDOs. Incidentally, the concern isn’t a new one as similar implications emerged following the Bear Stearns debacle just a month ago. Either way, it spells disaster for the US dollar as further fears of a weaker infrastructure are likely to exacerbate the already fragile state of the economy. Separately, Bernanke’s scheduled speech today was expected to lift dollar supporters in the afternoon. However, without really giving any directional bias on interest rates, the Chairman’s comments did little to boost greenback spirits.

Euro Makes Higher Ground, Pushes Past 1.3700
With no economic data on the day, Euro enthusiasts pushed the single currency higher on the session against a backdrop of US economic concerns. As a result, already trading higher at $1.3650 in the New York morning, EURUSD bullish positions had no trouble in taking out what seemed to be a highly option touted $1.3700 level. Now, with the exchange rate firmly above the psychological figure, market traders are eyeing a possible touch of the $1.3800 in the near term. Notably, with recent developments and the ECB rate decision, participants are continuing to price in the likelihood of a 25 basis point rate hike as soon as September. Coupled with overall dollar weakness in the market, Euro strength looks likely to remain supported for the week.

British Pound Takes On Fresh 26-Year Highs Just Below 2.0300
The British pound’s ascent against the US dollar was relentless today, as Cable hit fresh 26-year highs of 2.0276. While much of the move was based on major weakness in the greenback, a surprising narrowing in the UK’s trade deficit to the lowest since October 2005 certainly helped add a bid tone to the British pound. The visible trade balance hit -6.3 billion pounds, a substantial improvement from -6.9 billion the month prior, on the back of buoyant export demand from Asia and the rest of Europe. Meanwhile, Bank of England policy maker Andrew Sentance sounded hawkish when he said that reports “have suggested so far that the risk of overkill in restraining demand in the short-term was low,” signaling that the economy may be able to handle additional policy tightening. Until the markets perceive a more neutral bias from the BOE, British pound bulls could continue to reign.

Kathy Lien is the Chief Currency Strategist at FXCM.