To Hike or Not to Hike 'Tis The Dollar's Question

What only a few days ago seemed like a done deal is now rife with uncertainty. We are referring of course to the possibility of the Fed rate hike rate at the August FOMC meeting. Fed fund futures which in the aftermath of the "hot" CPI numbers earlier this week spiked to above 80% probability have scaled back the odds down to even money as the ramifications of Fed Chairman Bernanke's guarded testimony continue to resonate throughout the currency market. With the Fed signaling a more neutral rather hawkish posture, currency markets continued to sell dollars as US rate hike expectations are pared down.

In tonight's trading no currency has been the bigger beneficiary of this change in sentiment that the Japanese yen which up to now was the biggest victim of interest rate spread speculation. The yen fell to multi year lows against the British pound and near all time lows against euro earlier in the week but tonight yen appreciated materially with USD/JPY tumbling more than 100 points breaking the 116.00 level for the first time in five days. The move downward occurred despite statements by BOJ Deputy Governor Toshiro Muto that Japanese rates are likely to remain low for an extended period of time as the central bank tries to gradually normalize monetary policy to ensure that the ongoing Japanese economic recovery is not damaged in the process.

In the currency markets however, it is not the absolute value of the carry that matters but the future direction of the interest rate spreads. If the US rate hike cycle will indeed come to a halt at 5.5%, as many market players now anticipate, while the BOJ proceeds, albeit slowly, to push rates higher yen should continue to strengthen against the greenback. Tonight's price action may be a signal that the USD/JPY up move is finally exhausted, as traders cast their eye to the future of shrinking interest rate differentials between the two currencies.