The Nikkei took its cue from the strong Friday finish of the DJIA rising more than 450 points as a sense of stability returned to the financial markets. After initially trading down at the Asia open USD/JPY rebounded for the rest of the night rising as high as 115.50 when bargain hunters poured back into the carry trade on the assumption that the worst of market turbulence was over.

That, however, may be a big assumption to make. Volatility is likely to remain high in the currency market this week as traders try to grapple with the implications of last week’s events. The battle now is between those market participants who believe that that the current crisis is simply a problem of illiquidity versus those who think that the markets may be facing the much greater danger of insolvency. If the bulls are correct, then Fed actions on Friday may have been enough to calm the markets and the aftereffect of last week’s turmoil should not have much of a negative effect on the real economy. However, if the bears are correct and the current credit crunch leads to widespread bankruptcies and an economic slowdown, the fallout from last week will have lasting consequences.

For the time being, currencies will continue to watch warily the actions of the major stock market indices, and much of the price action in EUR/USD is likely to be driven by the movements in EUR/JPY as it responds to the constant shifts of sentiment towards risk. Economic reports will continue to take a back seat to the risk aversion theme, but ultimately it will be data that will determine the direction of FX. For the greenback, employment and consumption trends will be the key to ascertaining the health of the economy going forward and so far in August we’ve seen an appreciable uptick in weekly unemployment claims as they rose from the low 300K’s in July to approximately 320K in the first few weeks of August. As we wrote in our weekly, “The significant event risk of the week will be the Durable Goods data due on Friday. If US consumers are indeed starting to retrench the long term impact on the dollar is likely to be negative as traders will begin to price in the risk of recession.”

Finally, while currency traders remain preoccupied with the tick by tick movements of equities, news from UK indicates that inflationary pressures are not receding. Latest data from the Rightmove survey showed a very strong 12.8% year over year jump in house prices while M4 money supply expanded at very fast 13.0% rate. These are two critical variables that BoE considers seriously in formulating its monetary policy. While there is little chance that Mr. King and company will raise rates at the next MPC meeting given the turmoil of the past few weeks, if conditions stabilize, markets may once again consider the possibility of another rate hike from the UK central bank. In short 6% money from UK before end of the year may still be a reality, and that fact could prove positive for the pound as markets calm down.

Boris Schlossberg is a Senior Currency Strategist at FXCM.