The EUR/USD bounced back as the week began driven higher primarily by the rebound in EUR/JPY which rose nearly 200 points off the session lows as risk appetite and demand for carry trades returned across the board. All the high yielders including GBP/JPY, AUD/JPY and NZD/JPY we up materially during the night taking the component currencies along for the ride. Given the recent string of lackluster Japanese economic releases along with the very weak showing by ruling LDP party in the Upper House elections over the weekend, many traders remain convinced that BOJ will remain stationary at the August meeting, fearful to raise rates in an environment of such political and economic uncertainty.

Therefore, for carry traders last weeks sharp decline was yet another dip buying opportunity and they plowed back into the trade at the first sign of stabilization in the capital markets. Whether they are correct in their assessment or not will depend largely on the performance of equity indexes as the week progresses. As we noted in our week-end note, “In a battle between carry trades and risk aversion, the latter has the upper hand.” Thus the yen could still appreciate regardless of the disappointing Japanese fundamentals.

Euro rise overnight was blunted by the surprisingly weak Retail PMI data. The index dropped across the board with German, French and Italian readings all posting worse than expected results. Overall the report showed a very disturbing decline to 46.7 from 48.2 with the expected sales component decreasing to 51.8 from 56.3. For now there is little evidence that the expansion in the Euro-zone and the improvement in labor markets are translating into an increase in consumption. In fact the opposite is the case as the retail sector remains mired in contraction. None of this data can be viewed positively by euro bulls as the region will need to see a marked improvement in consumption in order to maintain its expansion, especially in light of the fact that US demand is likely to slow in H2 of 2007 providing little growth opportunity to EZ export industries.

Given the emptiness of the US calendar the rest of the day looks to be relatively quiet as markets consolidate the price action of last week. The one factor that of course could introduce more volatility into the day will be the action of US equity markets. If US stocks continue to decline sharply, the dynamic of last week will quickly reassert itself and tonight’s rally in the euro and decline in the yen will be seen as merely counter trend corrective moves as risk liquidation persists.

Boris Schlossberg is a Senior Currency Strategist at FXCM.