Fears of further problems among financial institutions dogged the currency markets at the start of the week as ECB announced yet another tender offer to infuse more liquidity into the jittery European money markets. The Der Spiegel magazine said that IKB bank - had EUR 7.8 billion of U.S. real estate exposure, which is double the EUR 3.5 billion bail out figure announced last week and suggests that European banks may be more vulnerable to the fallout from US sub-prime blowup than initially thought.

In overnight economic news, German wholesale prices jumped to 2.4% annual rate - a level that under normal conditions would be bullish for the euro as it would essentially assure an ECB rate hike in September. However, one of the results of the recent volatility in capital markets has been a marked decline in expectations of further ECB tightening. As we noted in our weekly, “After the BNP turmoil on Thursday, the ECB was forced to inject more than 130 Billion dollars into the system as European credit markets came to a grinding halt. Therefore, it is not unreasonable to speculate that the central bank may decide to hold off tightening monetary conditions given the very precarious nature of money markets in the 13 member region.“ Yet we also added that, “Such a move could have severe repercussions for the euro. The ECB prides itself on transparency and consistency, so a change of policy after essentially telegraphing a commitment to a hike could send the euro reeling not only on interest rate differential reasons, but also because it would suggest far deeper financial problems in the Euro-zone and undermine the case for euro as a viable alternative to the dollar. That is why we believe the possibility of a rate hike delay while real is remote for the time being.”

Meanwhile, Japanese economic data continued its disappointing track with Q2 GDP printing below forecast at 0.5% vs. 0.9% consensus call. Consumption was weak while exports declined as well. The news puts any notion of an August BOJ rate hike into serious doubt, but the yen strengthened nevertheless, partly on risk aversion dynamics, but also partly on the realization by market participants that the current climate of rising interest rates in G-10 economies may be coming to an abrupt end. If Central Banks from Frankfurt to London to New York are forced to lower rates to address liquidity concerns gripping financial markets than they would eliminate the primary raison d’etre for the carry trade – namely the expanding interest rate differentials between currencies. This in turn would alleviate the pressure on the yen as a funding currency as interest in the carry would wane.

Boris Schlossberg is a Senior Currency Strategist at FXCM.