Equity markets around the world are trading higher this morning but the sell-off in currencies and the decline in global bond yields suggest that there is a general sense of nervousness in the financial markets. The demand for U.S. dollars still reflects risk aversion as the greenback rises against all major currencies except for the Yen. USD/JPY is trading near 95, which is an improvement from its low of 93.80 on Thursday but still represents weakness for the pair. In fact all of the Yen crosses are trading lower today with EUR/JPY and AUD/JPY leading the sell-off.

Jon Hilsenrath’s article on the Federal Reserve’s plans for monetary policy in the WSJ yesterday created a bit of excitement at the end of the North American trading session but there has been very little follow through today as investors digest the mixed U.S. data and come to realize that equities may not deserve their lofty valuations. Hilsenrath claims that just because the Fed may alter its pace of asset purchases doesn’t mean that they are ready to raise interest rates. We agree as the central bank has tried to make similar comments in recent months. Nonetheless the focus is on the Fed with Bernanke and team gearing up for another monetary policy meeting next week that will be accompanied by their latest economic projections.

Based on the latest U.S. economic reports, the Federal Reserve should remain cautiously optimistic. Industrial production stagnated in the month of May after falling 0.4% in April, a sign that the momentum is fading in this part of the economy. Consumer confidence dropped to 82.7 from 84.5 in June according to the University of Michigan Consumer Confidence index. After rising to its highest level since July 2007, a pullback is natural. Americans have grown less optimistic about current economic conditions but their hope for the future brightened with the expectations component of the report rising to its highest level since November which is still promising for the dollar. Inflationary pressures also increased slightly last month as higher food and energy costs drive producer prices up 0.5% in May. Excluding food and energy PPI growth held steady at 1.7%. The current account deficit widened to -$106.1B from -$102.3B while foreign demand for U.S. dollars increased $12.7B in April. Unfortunately foreign investors were net sellers of long term U.S. Treasuries in April when 10-year bond yields fell from 1.85% to 1.65%. However we believe demand for dollars should have returned in May when yields spiked back up to 2%.

Looking ahead, the focus is on the U.S. equity market. If stocks continue to rise, the improvement in risk appetite should help some of the major currency pairs such as the EUR/USD recover. As for USD/JPY, 94.40 is the level to watch. If we get below this point, another test of the monthly lows is likely.

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