Dow Drops 226 Points, Dollar Tanks: Bloodbath Not Likely to be Over
On Monday, US stocks failed to recuperate all of Friday’s losses and today, the Dow has broken below Friday’s low. The last time we had an attempt at a reversal losses in the Dow were in excess of 400 points. We are now less than 275 points away from the record high set last week, which means that there is a strong potential for further losses in the Dow. Why is this so important for currency traders? Because the ebb and tides of the stock market is once again driving the direction of carry trades. Nothing new has unfolded over the past 24 hours, which suggests that the price action may be a reflection of the market’s expectations for this week’s housing market numbers. Existing home sales is due for release tomorrow. Pimco fund manager Bill Gross warned that the problems in the sub-prime sector could lead to a high yield crisis, but he has long been a housing market bear. The dollar fell to the lowest level against the Japanese Yen in 2 months. In addition to the existing home sales figures, Standard and Poor’s will also be holding a press conference at 10:30am EST on updated surveillance of Residential Mortgage Backed Securities and ratings actions of Collateralized Debt Obligations. More downgrades will not be taken positively by the markets, especially if they follow a weak housing number.

Euro Hits Record Highs Despite Evidence of Euro Driven Economic Weakness
The Euro climbed to a new record high today at the onset of US trading but the currency pair struggled to hold onto those gains amidst earlier data that revealed the first signs of Euro driven economic weakness. The current account balance came in much weaker than expected, with the deficit rising to 8.6 billion from 4.0 billion the prior month. Analysts were looking for an improvement since up until today’s releases the Eurozone was relatively resilient in the face of a strong Euro. The manufacturing PMI index also deteriorated more than expected which suggests that Thursday’s German IFO survey could fall more than analysts are currently predicting. The Belgian manufacturing survey, which is frequently used as a leading indicator for the IFO dropped 2 points in the month of July. Meanwhile we also heard one of the first Euro critical comments from an ECB official. Stark warned earlier today that exporters were being hurt by the strong Euro. Is this the beginning of more warnings about currency strength from the central bank? Probably not. There are no more scheduled speeches by ECB officials this week and next week, they go off on their month long summer holidays.

Carry Trades Continue to Sell Off as Risk Aversion Nears February Levels
Carry trades sold off across the board today with the biggest losses seen in AUD/JPY and NZD/JPY. The only Yen cross to remain immune to the liquidation was CAD/JPY which held steady thanks to stronger Canadian economic data. According the VIX, which is the equity market’s measure of volatility, risk aversion is nearing the levels that we saw back in February, when we had the 8.8 percent slide in the Shanghai stock market followed by the 3 percent sell-off in the Dow. The return of risk aversion makes the latest move more like liquidation than mere profit taking. It will be interesting to see if Mrs. Watanabe, who has stepped in to buy the yen crosses on any major dip will come back again to save the carry trades this time around. If we have significant follow through in the Asian stock markets tonight, traders will need to be careful of further USD/JPY weakness. The June corporate service price index and trade balance are due for release. These numbers will give us clues on how Thursday’s consumer price index will fare.

Is the British Pound Headed to 2.10?
The CBI Industrial trends survey dropped back into negative territory in the month of July, yet the British pound continued to rally. Many people have argued that rate hike expectations have been behind the 1000 pip rally in the currency pair over the past month, but if that was truly the case, then the less hawkish voting record from the most recent monetary policy meeting and the weakness of recent economic data should have put a dent into the currency pair’s rally. But instead of doing so, the GBP/USD pressed forward, hitting a new 26 year high on a near daily basis. The interest rate curve has been mostly unchanged since the beginning of the year. If anything, the front end of the curve has become flatter. Even though 6 percent is still baked into the markets, the “real” driver of the latest wave of pound strength is merger and acquisition flow. Flush with cash, foreign governments are on a buying spree and the UK has its doors wide open. Both Chinese and Middle Eastern governments remember the blocked Dubai ports deal and CNOOC’s bid for Unocal, leaving the UK as their preferred investment destination. To read more on what this means for the British pound, see our Special Report.

Canadian Dollar Hits New 30-Year High on Strong Retail Sales
The Canadian dollar hit a new 30 year high today after the release of May retail sales, which jumped by 2.8 percent, or five times more than market consensus. Such a result came on a jump in Building Supplies and Clothing, which rose 6.0 and 4.6 percent, respectively. The only negative component of the breakdown came from a mild drop in Furniture and Electronics sales, but this was hardly a cause for concern after last month's 1.4 percent growth. This drove both Canadian bond yields and the Canadian dollar higher. The market is now pricing in a 100 percent chance of a rate hike by the end of the year. There is no Canadian data due for release tomorrow, but Australia will be reporting consumer prices. They are expected to be firm like producer prices.

Kathy Lien is the Chief Currency Strategist at FXCM.