Carry came back with a vengeance tonight as calming news from the sub-prime market and reluctance of BOJ to raise rates beyond the current 0.50% level revived demand for high yielding currencies across the board. Yesterday’s announcement after the close of US equity trading that BoA purchased a 2 Billion dollar stake in Countrywide Mortgage alleviated trader’s fears that the country’s biggest mortgage originator was in danger of bankruptcy. Only a few days ago CFC was reduced to tapping it bank credit lines as the liquidity crisis reached its peak. The Countrywide news served as a critical catalyst in turning investor sentiment from risk avoidance to risk assumption.

In the currency market this dynamic translated into strong gains for the carry trade which was further aided by the BOJ decision tonight to keep rates steady at 0.5%, preserving the interest rate differential against G10 high yielding currencies such as the pound and the Australian dollar. As a result USD/JPY spiked to take out the 117.00 level as Japanese retail investors plowed back into the carry, taking out stops along the way. The BOJ decision was clearly affected by the recent market volatility and Governor Fukui warned that “Distortions and the misallocation of resources could occur if interest rates are kept at levels inconsistent with the economy.'' His pointed rhetoric suggests that the Japanese central bank will be ready to resume tightening monetary policy next month if global financial markets remain calm.

With little economic data on the calendar today, trading is likely to take its cue from the equity markets. If US stock traders take the Countrywide news in positive light, further rally in the Dow is likely to push USD/JPY higher. With risk appetite back all of the high yielders are poised to rise but that scenario is dependent two factors – the return the of normalcy to the markets and the belief that the events of the past week will have minimal impact on the real economy. We caution investors that prior periods of risk aversion typically resulted in further selling as credit contraction took its toll on economic growth.

Boris Schlossberg is a Senior Currency Strategist at FXCM.