Dollar Rebounds as Fed Officials Try to Calm the Markets
Federal Reserve officials are out in force trying to pacify the market after the Euro hit a new record high on the back of yesterday’s sharp dollar weakness. Philadelphia Fed President Plosser and Governor Warsh downplayed the impact of the problems in the sub-prime sector with Plosser repeating the Fed’s general belief that economic growth will recover in the second half. Following in the footsteps of Standard and Poor’s, rating agency Moody’s also put sub-prime loans on watch for a potential downgrade. A lower rating means not only a higher risk of default, but also higher interest rates. With hedge funds already facing increased margin requirements by investment banks, it won’t take much to cause a wave of default and liquidation if another sizeable loss is taken by a prominent lender. Of course, a big write down by a company like Washington Mutual would be needed to completely shakeup the market, but the more defaults that occur, the more stringent lenders will become, capping any near term recovery in US housing. Does this mean that the EUR/USD is headed to 1.40 then? Not necessarily. The weakness of the US dollar could also be the economy’s saving grace because not only will it keep demand domestic, but it will also boost manufacturing and exports. The trade balance is due for release tomorrow. A narrower trade deficit will remind traders of the benefits that a weak dollar can bring to the overall economy. On Friday, we are also expecting retail sales and import prices – both of which could help the US dollar recover. Although 1.40 is a tempting target for technical traders, it can only be achieved if we see dollar bearish numbers Thursday and Friday.

ECB Officials Continue To Talk Up the Euro
Contrary to popular belief, the European Central Bank is not worried about the current level of the Euro. ECB President Trichet said in a speech today that inflation risks are to the upside and even after the recent rate hikes, monetary policy is still accommodative. He also indicated that there is “no room for complacency,” which suggests that they could raise interest rates in September, right after they come back from their summer holidays. Trichet knows that the high level of the Euro reduces inflationary pressures, which means that wage growth must be so significant that the central bank is willing to risk pushing the EUR/USD up to 1.40, a level that will surely drum up strong political opposition. In an act of unity, ECB members Garganas, Stark and Hurley also made similar comments. In contrast to the problems here in the US, the ECB’s hawkish stance is driving the overall strength that we have seen in the EUR/USD. The ECB will be publishing its July monthly bulletin tomorrow along with their quarterly GDP forecasts. Strong numbers will add validity to the ECB’s hawkish inflation stance which will be perceived as Euro bullish.

Carry Traders Are Not Giving Up Yet; Don’t Expect Much from the Bank of Japan
The sell-off in carry trades yesterday cause a wave of concern that the major liquidation of risky assets has finally begun. Today’s rebound in the yen crosses however is a testament to the resilience of carry trades and the market’s unwavering demand for yield. Currencies pairs like GBP/JPY and CHF/JPY have not only rallied, but they have also recovered 100 percent of their prior losses. This indicates that the market is expecting nothing from the Bank of Japan who will be announcing its monetary policy decision this evening. The BoJ is widely expected to leave interest rates unchanged at 0.50 percent. Japanese economic does not support an immediate rate hike. CGPI, which is an inflation measure dropped in June. The only risk would be if the central bank decides to significantly upgrade their degree of hawkishness, which could be possible. The recent drop in the Japanese Yen has caused frustration around the globe. Hawkish comments could take some steam out of carry trades. Many analysts are looking for the BoJ to raise rates in September. Strengthening their tone at this time could also prepare the market for the inevitable.

British Pound – The Rally that Never Ends
The British pound rallied to a fresh 26 year high today despite the lack of UK economic data. The Bank of England is expected to be one of the most aggressive central banks this year, which explains why demand for the currency has been strong. It is important to note that we are beginning to hear increasingly divergent comments from Bank of England monetary policy officials. BoE’s Gieve warned that it is important not to overact with big jumps in interest rates, which could prove disruptive. BoE’s Sentance on the other hand was optimistic about growth which suggests that he will vote to raise rates again in the months to come. Central Bank Governor King on the other hand tried to squash speculation for either end of the spectrum by saying that rate decisions are not made in advance. This lack of clarity from the central bank is not surprising because they are renowned for catching the market off guard.

Australian Dollar Hits 16-Year High, New Zealand Dollar Stages Strong Recovery
It is clear that the market is still hungry for yield because the New Zealand dollar staged a very strong recovery today while the Australian dollar hit a 16 year high despite weaker consumer confidence. Australian employment figures are due for release this evening. Improvements in the employment component of manufacturing and service sector PMI suggest that job growth in the month of June could be strong. The Canadian dollar also recuperated the majority of its intraday losses. Commodity prices were steady so they are not likely to have had much of an impact on the currencies. Instead, merger and acquisition demand continues to fuel buying of the Loonie. The trade balance is due for release tomorrow. With manufacturing shipments and wholesale sales down, a weaker number is expected.

Kathy Lien is the Chief Currency Strategist at FXCM.