A very quiet night in the currency market as most majors simply marked time, unresponsive to the day's economic news. The yen lost some ground as mild risk appetite returned to the markets after global equity indices stabilized. On the economic front data showed that Monetary base contracted less than expected printing at –2.3% vs. –3% forecast. This was the best reading in 15 months and suggests that Japanese money supply is moving towards expansion albeit at a glacial pace that is unlikely to force any change in BOJ’s cautious, neutral stance.

For the time being yen continues to trade strictly on risk appetite dynamics with USD/JPY pair following the action in global equity markets almost tick by tick. However, that relationship may decouple and subtly shift into yen’s favor if currency markets begin to price in the prospect of a significant US economic slowdown along with the possibility of rate cut by the Fed. We believe that the Fed will remain stationary through the end of 2007. That forecast, however, depends on the assumption of minimum creation of at least 100K new jobs per month. Yesterday’s very soft ADP release which indicates only a 75K print in the NFP report this Friday was an ominous sign for any greenback bulls betting on the continuation of the carry trade. If employment data shows very little growth in the next several months, the FOMC may loosen monetary conditions in order to prevent the possibility of a recession. While a 25bp cut will not result in a significant change in the absolute value of interest rate differentials, the relative change in direction will be a major blow to market psychology, especially if it will signal the start of a new loosening cycle in the US. In such an environment the dip buying approach that has consistently rewarded carry traders over the past several years will likely fail as markets begin to anticipate further narrowing of the spreads.

Meanwhile, in Europe the focus is on rate increases rather than rate cuts. Both ECB and BOE are scheduled to make interest rate announcements later in the day and while neither is expected to make any changes during the dog days of August, markets are already handicapping the chances of September hikes from both central banks. To that end, the latest economic data is far more supportive of a BOE rate hike, rather than one from ECB. In UK over the past few days both Manufacturing and Construction PMI surveys surprised to the upside recording their best reading in years. Furthermore the latest Halifax housing survey showed a resumption of double digit price gains indicating that the demand for housing– a critical factor in BoE policy – continues to exert inflationary pressures on the system. On the other hand, this week’s EZ data from Retail and Manufacturing PMI surveys to German Retail Sales to today’s muted PPI figures all points to a slowdown in growth in the 13 member region. However, with BOE having already raised rates twice over the past three months while the ECB only hiked once during the same time frame, the UK central bankers may choose to wait in September while their European colleagues may decide to tighten. Nevertheless, this week’s disparity in data between UK and EZ bears watching closely. If this trend of UK strength and EZ weakness continues, market expectations will need to re-adjust and the EURGBP cross could see more downside as summer comes to a close.

Boris Schlossberg is a Senior Currency Strategist at FXCM.