The yen was the primary beneficiary of risk aversion today, as carry trade continued to be liquidated across the board in the wake of the American Home Mortgage fiasco and news out of Australia that several high yield investment funds were in trouble. Macquarie Bank, Australia’s largest investment bank revealed yesterday that two of its high-yield investment funds lost up to 25% of their value. The funds did not have direct exposure to the US subprime market but nevertheless suffered serious losses. The director of one of the funds, Peter Lucas, said that the underlying assets remained fundamentally healthy and fell by 4% in the month to July 30, but the leverage increased the loss to about 25%. He said that the funds were forced to sell assets to reduce leverage, but were not successful because of market conditions.

Indeed the problem in the capital markets across the wide array of riskier instruments is as much a function of excessive leverage as the result of disintegrating quality of underlying assets. Even relatively small markdowns have resulted in massive losses of capital as declines are amplified. Should this dynamic continue, it is likely to create even greater waves of risk aversion, spurring further liquidation of the carry trade. The yen of course continues to show the best relative strength in such an environment, but the dollar is an indirect beneficiary as well, as it becomes the temporary refuge from risk.

Economic data had only fleeting impact on trade tonight, despite the fact that Australian Retail sales showed the strongest increase in two years while UK PMI Manufacturing registered its best reading since 2004. The Aussie was sold heavily on fears that additional hedge fund losses could have a strongly negative impact on consumer psychology dampening any demand going forward. In UK meanwhile the strong results in the industrial sector took the market by surprise but the pound failed to find much traction as unit was hit with waves of selling every time it approached the 2.0250 barrier. Overall however, the news bodes well for sterling, especially in light of the fact that the industrial sector saw a jump in new orders despite the appreciation in the currency.

In the short term the moves in both the euro and pound will be dictated by investors attitude towards risk. One key factor this week will be US employment. If today’s ADP report confirms the creation of 100k+ new jobs, the equity markets may stabilize as investors will realize that the US economy continues to expand at a steady pace despite the problems in the financial sector. On the other hand more negative news on the economic front may drive USDJPY to 117.00 level and will take euro and sterling down as well.

Boris Schlossberg is a Senior Currency Strategist at FXCM.