The Euro and Japanese Yen are the most actively traded currencies in the foreign exchange market next to the US dollar. Over the past month, the Euro rose to a record high against the dollar while the Japanese Yen slumped to a four year low. The moves in both of these currencies have captured the world’s attention, especially since their one-way directional moves have become not so one-direction. The month of August could bring a tide of change for both currencies as Europe faces the lazy summer holidays while Japan could experience political turmoil during the Upper House Elections. Let’s take a look at what this could mean for the Euro and Japanese Yen in the coming month.

Vacation Time for Europe…And The Euro?

Though the Euro has eased back from its July 24th record high of 1.3851, the currency is still up nearly 17 percent since the beginning of last year. The combination of hawkish rhetoric and seven 25 basis points interest rate hikes by the European Central Bank has driven the EUR/USD from 1.20 to 1.3850 in a little more than a year. However, the month of August represents a lull in activity for Europe, as workers – including central bankers, Finance Ministers, and traders – typically go on holiday. Will we see a slowdown in the Euro’s pace as well?

Europeans are known for their extensive vacation time, and the month of August is perhaps the finest example of this as many workers leave their offices and escape on holiday – including the board members of the European Central Bank. Though the ECB will conduct their monthly monetary policy meeting on August 2nd, it will be done via teleconference. With inflation still below the central bank’s 2.0 percent target at 1.9 percent, there is very little chance that they will surprise the markets with a rate hike. Usually, this would make ECB President Jean-Claude Trichet’s regularly scheduled press conference following the rate decision extremely important, as traders use the commentary as a gauge for future policy actions (remember how important the phrase “strong vigilance” was just a few months ago?). With no rate hike and no hawkish commentary from Trichet, what do Euro bulls have to look forward to? And more importantly: will conditions in August favor a turn lower for the currency?

When Trichet Is Away, Will Sarkozy Come Into Play?

If the European Central Bank is the Euro’s cheerleader, French President Nicolas Sarkozy is the saboteur waiting in the wings. Like his predecessor, Jacques Chirac, Sarkozy has been outspoken about his dismay with the appreciation of Euro and has criticized the ECB’s exclusive focus on the inflation. ECB President Trichet has been quick to fire back, saying that Sarkozy's proposed tax cuts would violate a French pledge earlier this year to reduce the nation's budget deficit. While other European leaders, such as Italian Prime Minister Romano Prodi have remained mum on the issue publicly, many regions in Southern Europe have felt the negative impact of a stronger Euro on exports. As a result, Trichet’s comments highlight a more important issue that sheds light on the national differences in opinion on the Euro: reforms.

Notice that German Chancellor Angela Merkel has scarcely said a word about the jump in the Euro and has actually remained a staunch defender of the ECB’s independence, as her country is far more prepared to cope with a stronger national currency. This is because the German manufacturing sector has already endured a tough restructuring, which has helped keep inflation in check. In fact, manufacturing unit-labor costs in the country have dropped 10 percent since 2003 versus a jump of 11 percent during the same period in Italy. Furthermore, labor market reforms have helped boost labor productivity in Germany, as the OECD reported an improvement of 2.2 percent between 2005 and 2006, while France saw a more tepid 1.2 percent rise and Italy edged up less than 1.0 percent.

Given these circumstances, Sarkozy’s stance isn’t entirely surprising. However, with many central bankers unlikely to be in the press during the month of August and thus, unable to talk up the Euro by discussing upside inflation risks or by expressing the fierce independence of the ECB, there are even more opportunities for Sarkozy’s battle cries against the Euro to be heard.

What About Economic Data?

Nothing unusual is scheduled for release out of the Euro-zone over the next few weeks, and only two economic indicators are likely to draw much attention: GDP on August 14th and CPI on August 16th. Estimates for expansion in the second quarter are not available yet, but while we’ve seen resilience in exports along with continued consumption growth, GDP is likely to slowdown slightly from first quarter’s red-hot annualized pace of 3.1 percent. Meanwhile, CPI for the month of July should hold below the ECB’s 2.0 percent target for the 11th consecutive month, as inflation growth has remained relatively consistent and mild across the board. Barring major upside surprises, fundamental data alone does not provide major potential to spark a large Euro buying spree. If anything, the combination of sparse hawkish ECB rhetoric along with lackluster economic reports may only set the stage for softening of the Euro during August.

The Japanese Yen and the Upcoming Domestic Elections: LDP Victory Bullish for USDJPY?

The Japanese Yen on the other hand has recovered a good portion of its recent losses over the past few trades. However uncertainty surrounding the upcoming Japanese Upper House Election may place pressure on the Yen through the short term. Scheduled for Sunday, July 29, voters will decide whether the ruling Liberal Democratic Party will maintain a majority in the upper house, which has important implications for the broader Japanese economy and government policy. Prime Minster Shinzo Abe’s majority is in clear danger of an embarrassing loss; opinion polls show that voters have grown increasingly dissatisfied with the PM and his cabinet. Though the Upper House has relatively little political power, it does have the ability to block legislation and thus serves a key role in the premier’s plans for reform.

One of the important issues in the upcoming election is the proposed raise in the national consumption tax. Though Prime Minister Abe has clearly tried to distance himself from such a largely unpopular topic ahead of voting, political analysts claim that an LDP victory will likely bring a hike in the sales tax. A national deficit at 150 percent of Gross Domestic Product forces the government to raise revenues however way they can. Yet other major parties have plainly said that they will leave the consumption tax exactly unchanged at 5.0 percent—seemingly a ploy to take votes away from the leading LDP politicians.

Subsequent implications for consumer spending and sentiment are relatively clear; an LDP defeat and a stable consumption tax may prove bullish for consumption through the medium term. Currently anemic consumer spending rates have definitely shown their impact on economic growth, keeping pressure on the Bank of Japan to limit monetary policy tightening in the absence of a pickup in expenditures. If the LDP wins it may prove bullish for the Japanese Yen through the shorter run; traders typically dislike political instability and an embarrassing loss could bring the resignation of Shinzo Abe. Yet if the LDP does indeed hold its majority, we would likely see a tax hike down the line and a worsened outlook for the health of domestic consumption. This could hurt the chances of a continued turnaround in headline household spending, which has shown modest signs of stabilization after sharp slowdowns in 2005.

Carry Trades Hold Key for Yen Performance

Also impacting the movements of the Japanese Yen is of course carry trade demand. A recent rise in risk aversion has dented the long term profitability of carry trades. The key question remains whether we will see a continued Yen rally, with the answer likely to depend on one key factor – risk appetite.

Risk appetite—and not the typical fundamental factors—seems to be the primary driver of Japanese Yen price movements. Such sentiment can be measured by a broad range of popular indices, with many forex traders looking to the implied volatilities on forex options as the de facto barometer of risk appetite. It is subsequently little surprise that the recent USDJPY tumbles have come on a surge in the prices paid for currency options, with 1-Month implied volatility on Yen contracts surging over 2 big points off of June lows to 8 percent through time of writing. Such gains in implied volatilities suggest that speculators expect increasingly sharp moves in the Yen through the short-term. The carry trade is undoubtedly a strategy that depends on relatively stable price action for greatest success. As such, any continued advance in market jitters and subsequent gains in implied volatility bode poorly for the popular Yen short strategy.

The USD/JPY and the EUR/JPY: Where to Next?

Although the EUR/USD could give back some of its recent gains, the US Dollar and Euro may continue to lose against its similarly downtrodden Japanese counterpart, as overall market jitters will almost guarantee continued Yen advances. Similarly significant, the market may be primed for a continued shakeout of overextended Yen shorts. As our Technical Analyst Jamie Saettele wrote in this past weeks CFTC Commitment of Traders analysis report, “The psychological backdrop is ripe for a reversal again so be on the lookout for a top in the JPY crosses.” This was especially true for the British Pound-Japanese Yen pair, which was in incredibly overbought positioning on a brief foray above the psychologically significant 250.00 mark. (Read here for the full DailyFX COT Report) Barring any sudden shift in overall risk sentiment, we believe that the EURJPY may likewise be in store for further correction, especially as the Euro could be plagued by lackluster data and see little hawkish rhetoric by the ECB. The USDJPY may be the best performer among the Yen pairs, however, as the dollar typically benefits from a flight to safety across global asset markets.

Terri Belkas is a Currency Strategist at FXCM.