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The Forex markets reacted swiftly and decisively after Fed Chairman Bernanke announced that economic risks have faded and implied that interest rates may have to go up to fight rising inflation.

Bernanke has always been concerned about fighting inflation. He spoke of the Fed's battle with inflation way back in January, but the financial crisis got in way and gave him no choice but to shore up the economy by cutting rates.

Earlier in the year, Bernanke urged the financial sector to start raising its own capital. This was the first sign that his focus was going to shift toward thwarting inflation. He and the Fed have exhausted all means to shore up the financial crisis and loosen up lending. His focus had to shift toward preventing runaway inflation.

Last week he stated that the Fed and the Treasury were well aware of the effects of a weak Dollar and crude oil prices. He saw what his comments did to the price of crude oil. This week he decided to come back with even stronger comments in an effort to break the oil once again.

Bernanke's counterpart at the ECB, Trichet, is already on record stating that he will raise rates in July if necessary in the Euro Zone. The question is: will the Fed match this rate hike with a hike of its own in August?

Financial traders who bet on the direction of interest rates by committing to spread positions are already factoring in the possibility of a rate hike on August 5. The sentiment rose in one day from 31% to 52%. Traders have also increased their bets that the Fed will raise rates in December from 67% to 96%.

With the Euro heading toward the low end of its 2-month range, it will be interesting to see if Trichet comes back tonight or tomorrow with even more hawkish language supporting the Euro to send it back up. This financial tennis match is expected to continue until one of these leaders hits the ball out of the park. In other words, look for the Euro to continue to trade between 1.52 and 1.60 or both sides of 1.56 until the market starts to believe either Bernanke or Trichet.

Bernanke's Comments Support USD/JPY

The USD/JPY rallied on Tuesday as the technical breakout continued. Traders cite the strong comments by Bernanke supporting an interest rate hike to prevent inflation from spreading as the main cause of the rally.

Keep in mind that a carry trade does not always mean money will go into the stock market. The money actually seeks the highest yielding asset. With interest rates rising, some traders are selling borrowed Yen to invest in safer yielding treasuries. Speculators are latching on to the USD/JPY as the interest rate differential is widening between the two countries.