The EURUSD hit all time highs in overnight trade, coming within a whisker of the 1.3800 level as bullish GDP data and supportive comments from German Economy Minister Michael Glos, maintained the rally in the pair. The final reading of the Q1 Euro-zone GDP printed a bit better than expected at 3.1% vs. 3.0% forecast in large part due to upward revisions in Industrial Production. Much to the surprise of many analysts, the higher value of the currency has not been a serious barrier to growth in this key export sector. Indeed Mr. Glos’s comments affirmed that idea, as he noted that Germany was prepared to live with higher euro levels.

One positive effect of the higher exchange rates for the Euro-zone has been to lower the cost of oil (which is priced in dollars) for the region’s producers. This in turn has helped to contain much of the upward pressure on input costs and has led some policy makers to argue that ECB should remain neutral with respect to interest rate policy for the time being as the higher euro is acting as natural counterweight to any inflationary pressures resident in the system.

Whether the central bankers in Frankfurt accept that reasoning remains to be seen. Many of the ECB hawks continue to be concerned with unrestrained credit growth in the region which has fueled double digit gains in M3 money supply. Nevertheless, despite the sunny Industrial Production data ECB authorities understand quite well the long term implications of a strong currency. For the time being EZ producers may be able to weather the impact of the rising euro through the use of long term hedges and incremental improvements in productivity, but once those measures wear off the Industrial sector will face serious competitive challenges and perhaps a drop off in demand. That in turn may cause the ECB to hike rates only once rather than twice this year taking some of the speculative fervor out of the rally in the EURUSD

Meanwhile across the Pacific, the BOJ offered nothing new to the market keeping rate steady at 50bp as expected. Governor Fukui did note that Q2 GDP may be slower than Q1 data, but stated that the economy continues to expand. The overall vote was 8-1 in favor of neutrality and offers little direct evidence than Japanese monetary policy makers will shift to a more hawkish posture in August. Still, without the prospect of an August rate hike the yen is likely to decline further beyond the 125.00 level in the USDJPY.

In the exact opposite dynamic to Europe, such a move would only exacerbate the unfavorable input cost environment of the Japanese producers who are already burdened with rapidly rising energy costs. Therefore, despite today’s non-committal vote chances are good that BOJ will hike rates to 75bp in August. However, the BOJ current modus operandi is to raise rates every six months, and that pace of tightening will not be enough to curtail the carry trade. Only when the central bank shifts to a more aggressive once-every-three-months schedule, will the carry trade begin to turn in earnest.

Boris Schlossberg is a Senior Currency Strategist at FXCM.