Why the US Dollar Could Rebound this Week
Since the beginning of the year, one of the best trades in the currency market has been to short US dollars. Although we think that the dollar will continue to fall over the next few months, there is a good chance that it could rally this coming week. We have two pieces of data that could trigger the rally, Tuesday’s trade balance report and Friday’s consumer price release. With oil futures closing above $107 a barrel, inflation is a big problem. The Boston Globe has some great graphics on rising food costs. According to their report, egg prices have increased 50 percent over the past 2 years, while the prices of a red delicious apple and a gallon of whole milk have increased 20 percent. For the time being, retailers appear to be absorbing the costs. This weekend’s Financial Papers have extensive coverage on how restaurants are substituting ingredients or altering their menu offerings in order to reduce costs without raising prices. None of these changes would need to be made if increasing food prices are not hitting the bottom line. It can be argued that headline inflation may rise sharply but the growth of core prices will remain muted. However with gasoline prices in many states hitting record highs, prices of goods excluding food and energy should begin to rise as well. As for the trade balance, which is more immediate, the weakness of the US dollar should have helped to increase exports and reduced imports. The risk of course is the retail sales report in the middle of the week. Consumer spending is expected to be weak, but rising prices could also boost the value of the goods sold. Wholesale inventories have increased nonetheless which suggests that even though hiring has slowed and the US economy has weakened, this has not stopped business leaders from restocking their shelves. Meanwhile intervention is the big buzz word in the currency market today but do not expect the Federal Reserve to participate. Whether they admit it or not, they like the fact the US dollar is falling because it is currently supporting growth by boosting exports.

ECB Trichet: Concern Is Not the Same as Brutal
This morning, ECB President Jean-Claude Trichet said that he is “concerned about excessive exchange-rate moves.” This is the first time since November 8, 2007 that Trichet has specifically expressed concern about the move in the Euro. Back then, he called the rally above 1.46 “brutal.” That led to a 200 point drop in the EUR/USD that lasted for no longer than 24 hours. This was the same phrase that Trichet used back in November 2004, which eventually led to a top in the EUR/USD, but not until 2 months later. “Concerned” is definitely a step down from “brutal” but it is important to understand what Trichet is trying to tell us - which is that he cares about what is going in the currency. However for the time being his concern is still limited. The last time the ECB intervened was in 2000 and that was to strengthen the Euro shortly after its launch. If the 13 percent rally in 2004 triggered nothing but verbal intervention, don’t expect the 6 percent rally year to date to stress Trichet out either. Meanwhile the German ZEW survey is due for release tomorrow. Recent economic data from the Eurozone has been good which should help to reduce overall pessimism.

USD/JPY: At Risk for Intervention?
As USD/JPY nears 100, intervention risk grows but will the Bank of Japan really take action after sitting on their hands for the past 4 years? Probably not. This is not the first time that USD/JPY has traded on the 101 handle without BoJ intervention. Back in late 2004, early 2005, USD/JPY hit a low of 101.70 and the BoJ did nothing, The main reason why the BoJ has not intervened over the past few years is because they want to lead by example and encourage China to make their exchange rate more flexible. If they intervene, it would set back all of their efforts. However intervention from Japan is still more likely than intervention from the Eurozone because Japanese corporations are beginning to suffer. The most recent Tankan survey showed that most Japanese corporations forecast the value of USDJPY in 2008 to be around 113.00. With the pair now rapidly approaching the 100 level, those hedges are deep in the red. However if they were to intervene, now would be a good time because positioning in the Japanese Yen is at an extreme, giving them the most bang for their buck. Yen long positions are at the highest levels since Feb 2004, right before the last BoJ intervention. USD/JPY short traders need to be particularly wary about intervention risk at this time.

Australian, New Zealand and Canadian Dollars Continue to Plummet
The Australian and New Zealand dollars continued to plummet as the Dow dropped another 150 points to a 6 week low. There was no data released from either country and gold prices continued to fall which means that risk aversion is the primary driver. The same can be said of the Canadian dollar because it also fell significantly despite stronger housing starts and another record high in oil futures. The Canadian trade balance and the new housing price index are due for release tomorrow. We expect both of these numbers to be CAD positive but it remains to be seen whether that will have a lasting impact on the Canadian dollar.

British Pound Weakens Against Euro and US Dollar
The British pound gave back its earlier gains against both the Euro and US dollar. Economic data was mixed with the annualized pace of output prices increasing less than expected but input prices increasing more than expected. Industrial production fell short of expectations as well, but manufacturing production rose in the month of January.

Kathy Lien is the Chief Currency Strategist at FXCM.