FOREX EUROPE UPDATE - USD

The carry trade suffered further overnight as BoJ hawk Suda said prolonging low rates could cause currency risks.

During the Asia session the dollar traded in a firm 1.2953-1.2972 range against the EUR, and a weaker 120.19-121.21 range against the JPY.

Policymakers globally upped the stakes against the carry trade yesterday, beginning with a Reuters report citing unnamed sources that the Europeans will seek a more forceful repetition of the message that the yen should trade in line with economic fundamentals, at next month's G7 meeting.

Meanwhile, carry sentiment has been hit by a string of bad economic news among the high-yielding bloc. Australian CPI was soft yesterday, the BoE MPC minutes were more dovish than expected, and the RBNZ kept rates on hold this morning. However, as has been demonstrated countless times over the past year, the underlying appetite for carry is not dented so easily.

As long as global financial market volatility remains low, and yield differentials between high- and low-yielders remain wide, then the fundamental arguments for a continuation of the carry trade remain.

With the outlook for global growth taking a turn for the better in recent weeks, elevated levels risk appetite may not easily diminish-our Risk Index for FX has stayed in risk-seeking territory since August. We are always wary however of a major carry breakdown.

The "big unwind" of carry could have many different catalysts. Positioning in the carry trade is very high, so a small economic development could trigger big ramifications regardless of other fundamentals. Otherwise, a reduction in liquidity provided by hedge funds (a fear of many central banks) could also unnerve investors, while a natural disaster or a geopolitical event could also prove a catalyst. An evolution in FX policy by Japan and the SNB to the point of threatening intervention to buy the yen and Swiss franc would also have a significant impact.

However, with Japan PM Abe struggling in opinion polls and the Upper House election approaching in summer, Japan's political appetite to counteract the weak yen is not there, and hence the G7 meeting is unlikely to mark the peak in the yen-funded carry trade. An unwind in carry when it eventuates will be negative for the dollar, but our principle arguments for a weaker dollar rest on expectations of slowing US activity data and the likelihood of Fed rate cuts from May onwards.

Today we have weekly jobless claims at 1330 GMT and existing home sales for December at 1500 GMT.