US Dollar Recovers: But the Losses May Not Be Over
Equities, bond yields and the US dollar all recovered today amidst the lack of any US economic data. However, none of these assets managed to regain all of Friday’s losses, which suggests that the selling may not be over. This week’s major event risks do not come until Wednesday at which time we will learn more about how much the situation in the housing market has worsened. If existing and new home sales continue to fall, then Fed Chairman Bernanke’s claim that things will get worse before they better is supported. If they rebound however the market will continue to downplay the risks of a collapse in the housing market, just as they have in the past. It has become a “show me” world, where the investors need proof before bailing out of the risky positions that have afforded them consistent profits. The continual rise in high yielding currencies such as the British pound, New Zealand and Australian dollars is a clear sign that the market hasn’t given up on assuming risk. Don’t expect the US government to stand in the way of further dollar weakness either. They will continue to pay lip service to a strong dollar policy, while banking on a weak dollar to pull the US economy out of its current slump. One of the primary reasons why the housing market has not collapsed yet and why the stock market remains not far from its record highs is because of the widespread benefits of a weak dollar. The manufacturing sector is recovering strongly thanks to booming exports. The latest survey of business economists revealed that profit margins increased for the 16th straight quarter. Optimism is increasing which has translated into stronger capital spending and productivity. Even though traders and investors are nervous about the housing market, they will need to see proof of the situation deteriorating before bailing – at which time a true liquidation will not be as forgiving as the corrections that we have seen over the past 2 months.

Euro Hits New All-time High but Fails to Hold Onto Gains
The Euro climbed to a new record high today in the early Asian trading session, but failed to hold onto its gains. This type of price action should be worrisome for Euro bulls, but we would need to see a close below 1.3780 to turn bearish. This is the last chance that we will hear from ECB officials before they go on their summer holidays. The lack of concern over the past few weeks tells us that they fully intend to raise interest rates to 4.25 percent over the next few months. As recently as this morning, ECB member Papademos pointed out that some EZ countries have raised their growth rates while Stark talked about how the current level of the Euro reflects the strength of the economy. Next month’s monetary policy meeting will be a teleconference with no scheduled press conference. Although Trichet has warned that holding an impromptu press conference may not be out of the question, we expect him to wait until the September meeting to bring back the words “strong vigilance.” At that time, he would be preparing the markets for an October rate hike. Given Trichet’s warning to EU government officials about interfering in ECB monetary policy, unless we see the EUR/USD at 1.45 in August, we do not expect to hear much from Trichet next month. Instead, what could lead to some further Euro selling is this week’s busy data calendar. Tomorrow we are expecting EZ service and manufacturing PMI along with industrial orders and current account. All of these reports are sensitive to exchange rates, which mean that they have decent chance of surprising to the downside.

Chinese Investment into UK Bank Sends Pound Soaring
The British pound continues to be one of the biggest beneficiaries of US dollar weakness. The drop in house prices has been offset by the news that one of China’s state owned banks has bought a 3.1 percent stake in Barclays, one of the UK’s biggest banks. Valued at US$5 billion, this stake could grow to $18.76 billion (with the help of Singapore’s Temasek Holdings) if Barclays manages to win the bid for ABN Amro. With 1.2 trillion in reserves, China is on a buying spree. Over 2 months ago, they announced that they will be starting their own investment fund. After investing $3 billion into Blackstone, China has now diversified across the Atlantic. The market is also continuing to talk of 6 percent rates in the UK despite mixed economic data. Tomorrow we are expecting CBI industrial trends orders; strong numbers could mark another multi-decade high in the British pound.

Carry Trades: Is this Profit Taking or Liquidation?
Friday’s sell-off in the Yen crosses was driven by the fear that the problems in US sub-prime sector have become global. So far we have learned that they have not and because of that, some of the Yen crosses have recovered. GBP/JPY and NZD/JPY both rallied to decade or multi decade highs. EUR/JPY hit an all-time high before reversing. Carry traders are being more selective, but demand hasn’t abated yet. Japanese retail investors are still taking each dip as a new buying opportunity and they will probably continue to do so unless we see a sharp 1000 pip breakdown in the yen crosses. According to an article in the Nikkei paper, the value of Japanese investment into foreign trusts has increased 56 percent. The market’s appetite for carry trades has also been fueled by their expectation of nonexistent inflation. Consumer prices are due for release this Thursday night; another negative month is forecasted. Meanwhile the LDP elections are scheduled for Sunday. The latest opinion polls indicate that Prime Minister Abe and the LDP are losing support. This has weighed on both the Japanese Yen and Japanese equities.

Australian and New Zealand Dollar Register More Gains
The Australian and New Zealand dollars continued to hit new highs today on the back of stronger Australian producer prices and speculation that the Reserve Bank of New Zealand will be raising interest rates to 8.25 percent later this week. The market is currently pricing in a 70 percent chance of a rate hike and even if they do not raise rates, the market expects the RBNZ to remain hawkish. This has helped both the Kiwi and Aussie. The Canadian dollar on the other hand has also gained ground ahead of tomorrow’s retail sales report. Given the up tick wholesale sales last week, the market is looking for consumer spending to remain steady. Although the currency pair is attempting to bottom, another upside surprise could easily drive the pair to a new 30 year low.

Kathy Lien is the Chief Currency Strategist at FXCM.