This is article is released weekdays under the heading Daily Fundamentals at 5pm EST on www.dailyfx.com

• Japanese Yen Driven by Risk Trends, But Threat of Political Instability Looms in August
• Euro, British Pound Gain Against Safe Havens, Data Prevents Increase Against Other Majors
• New Zealand Dollar Rally May Be Hindered (or Helped) By Upcoming Inflation Data

US Dollar Down as Optimism Fuels Demand for Carry Trades - Threat of Risk Aversion Lingers
The US dollar and Japanese yen were the weakest of the majors as investor confidence surged, driving up FX carry trades and sending the DJIA and S&P 500 up roughly 3 percent. For evidence that the dollar's decline was driven by risk trends rather than fundamentals, one must only look to the US data on hand. First, the US consumer price index (CPI) rose more than anticipated at a rate of 0.7 percent in June, driven by energy prices, though the annual rate did fall to -1.4 percent, the lowest since January 1950, from -1.3 percent. Meanwhile, the Federal Reserve Bank of New York's Empire manufacturing index jumped up to a 15-month high of -0.55 in July from -9.41, with a breakdown of the report showing a surge in prices paid, new orders, and shipments.

However, the release of the minutes from the Federal Reserve's June meeting left the markets on edge, cutting rallies in FX carry trades short amidst changes to growth and inflation forecasts. Furthermore, central bankers generally expressed doubts that expanding their quantitative easing program would have much of an impact, indicating that traders should not expect increased Treasury purchases anytime soon. Taking a closer look at the Fed's projections, inflation forecasts were revised slightly higher, suggesting that the central bank doesn't anticipate deflation becoming an issue, while 2009 GDP projections were revised up to -1.5 percent to -1.0 percent from -2.0 percent to -1.3 percent, and the 2009 unemployment rate forecasts were changed to 9.8 percent to 10.1 percent from 9.2 percent to 9.6 percent.

In other news, trading of CIT Group, a large and troubled commercial lender, was halted this afternoon, suggesting that some sort of news will be released soon. This leaves the question open of whether they will they be deemed as being too big to fail, but the market's response to the news may be negative either way. Indeed, a bailout would set a precedent that the US government will save anyone, which feeds moral hazard, while a bankruptcy filing by CIT would highlight the fact that financial market conditions remain unstable. There are other potentially ominous pieces of news that will be released through the end of the week: JPMorgan Chase will publish Q2 earnings on Thursday morning while Bank of America, Citigroup, and BB&T will publish theirs on Friday. Of the four banks, only Citigroup is expected to announce another quarter of losses, but following the astonishingly strong results we saw from Goldman Sachs on Tuesday, there's a risk that the bar has been set too high and any disappointing result could resonate deeply with investors and spark flight-to-quality toward the US dollar and Japanese yen, while weighing on carry trades and stocks.

Related Article: FOMC Minutes Cause Carry Trade Rallies to Pause as Fed Indicates No QE Expansion, Weaker Labor Markets

Japanese Yen Driven by Risk Trends, But Threat of Political Instability Looms in August

The US dollar and Japanese yen were the weakest of the majors as investor confidence surged, driving up FX carry trades and sending the DJIA and S&P 500 up roughly 3 percent. In the near-term, there is potential for carry trades to reverse in favor of Japanese yen bulls as we will soon find out the status of troubled commercial lender CIT Group, JPMorgan Chase will publish Q2 earnings on Thursday morning, and Bank of America, Citigroup, and BB&T will publish theirs on Friday.

There are risks to keep in mind in about a month as well, as Japan's Prime Minister Taro Aso recently called for an election on August 30. Both the ruling Liberal Democratic Party (LDP), to which Aso belongs, and the opposition Democratic Party of Japan (DPJ) have been calling for an early election since last September. The threat here is that the LDP could be booted from power after more than 50 years of governing Japan, creating political instability. Furthermore, the shadow finance minister of the DPJ, Masaharu Nakagawa, said this week that Japan should diversify its currency reserves in the medium to long term in order to avoid the risk of currency losses or economic turbulence that could result if the dollar were to swing, and start considering investment in International Monetary Fund bonds. Any instability derived from a shift in power to the DPJ could cause trouble for the Japanese yen, but it may also create problems for the US dollar as talk of sweeping changes to central bank reserves is enough to hurt the greenback.

Euro, British Pound Gain Against Safe Havens, Data Prevents Increase Against Other Majors
The euro and British pound jumped against the US dollar and Japanese yen, but this was only because the latter two were so weak amidst broad-based risk appetite. However, data didn't necessarily work in favor of euro or British pound strength. First, the UK jobless claims change rose for the 16th straight month in June by 23,800, and while the claimant count rate held at 4.8 percent, the ILO rate jumped to a more than 12-year high of 7.6 percent from 7.2 percent. Second, the Euro-zone consumer price index rose 0.2 percent in June, as expected, but that did not prevent the annual rate of growth from falling to -0.1 percent, indicating a contraction in prices for the first time since records began in 1996.

Related Articles: Euro Weekly Trading Forecast, British Pound Weekly Trading Forecast

New Zealand Dollar Rally May Be Hindered (or Helped) By Upcoming Inflation Data

The New Zealand dollar has been on a tear today, surging across the majors but especially against the ultra-weak Japanese yen and US dollar as increased risk appetite spurs demand for carry trades. However, the currency will face significant event risk at 18:45 ET as New Zealand's consumer price index is forecasted to have risen 0.5 percent during Q2, which could bring the annual rate down to a nearly two-year low of 1.8 percent from 3.0 percent. As it stands, Credit Suisse overnight index swaps are pricing in a slight 25 percent chance of a 25 basis point rate cut to 2.25 percent, but if the latest inflation results reflect a sharp drop in price growth, the odds could shift in favor of looser monetary policy and the New Zealand dollar could fall. On the other hand, if inflation pressures prove to be stronger than anticipated, the currency could rally.

For the most up-to-date forex analysis and news, visit: www.forexstream.dailyfx.com
**For a full list of upcoming event risk and past releases, go to
www.dailyfx.com/calendar

Written by: Terri Belkas, Currency Strategist for DailyFX.com
E-mail: tbelkas@dailyfx.com