• Surprising Decline in Trade Deficit Helps Dollar to Extend Rally
• Inflation on the Rise in Europe and the UK
• Weak Economic Data Sends Yen Tumbling

US Dollar
During the US trading session, the dollar continued to gain strength against the euro even though it ended the day virtually unchanged.  The trade balance came in much better than expected, narrowing from an upwardly revised $59.5B to $57.9B for the month of July.  The market had expected the trade deficit to increase due to rising oil prices, but an up tick in exports to record levels helped to narrow the overall balance. China has been increasing its appetite for US goods, with exports to the country also rising to a record high.  It seems as if the effect of higher energy prices on demand has been more significant than the upward pressure that it is exerting on input prices.  The detail of the release indicates that the demand for pharmaceuticals, clothing and aircraft have all fallen during month of July.  It is important to reiterate that the trade balance is for July, which means that it does not include the impact of Katrina.  The move in the dollar suggests that the market recognizes that the data is delayed and not a particularly reliable indicator of the health of US economy.  This is the same sort of price action that we saw in the non-farm payrolls number released earlier this month.  The trade balance is expected to get progressively worse over the next few months.  In August, crude oil prices increased 17%.  The closure of the ports in the Gulf States should have had a negative impact on imports. Meanwhile, producer price growth was also softer than expected, with the headline index rising only 0.6% in the month of August and core prices remaining unchanged.  This raises the question of whether higher energy prices are actually having a disinflationary effect on other products. 

Euro
Consumer prices in the Eurozone edged higher in the month of August despite mediocre growth.  Today's report brings forth the ECB's tactic to focus their attention on inflation rather than growth * which has been steadily rising.  The French trade deficit increased to EUR 2.6 billion from EUR 1.3 billion in the month of July.  Weak domestic demand has dragged exports lower once again, which continues to come in contrast to the improvements that we have been seeing in Germany.  At the polls, Merkel and Schroeder's party continues to advance head to head, with neither commanding a strong majority.  Tomorrow we have a light Eurozone economic calendar, so all eyes should be focused on the US Retail sales and Industrial Production reports.

British Pound
Another blow to further interest rate cut speculation was felt today as inflationary pressures rose above the central bank's target for another month.  Already above the 2% benchmark at 2.3 %, consumer prices increased to 2.4% in the month of August, the highest level in at least 8 years, according to the Office for National Statistics.  This means that given the hawkish ideology of central bankers, concerns over sluggish consumer spending and staid housing valuations will have to take a back seat while persistent worries over climbing energy and oil costs move to the forefront. Reflective of current difficulties, U.K. Chancellor Gordon Brown urged other industrial economies to take certain measures in stabilizing the current prices of oil as certain sectors continue to be on the decline.  Most notably, domestic airlines, where fuel costs constitute close to 25% of overall inputs, and domestic trucker strikes have grabbed the attention of policy makers in recent days.  Ultimately, this places Governor King and company in an interesting position with many previously expecting further rate cuts as called for by several sources including the Confederation of Business Industry to improve the current economic landscape.  In any case, traders are already siding with the notion of no further cuts for the year as the implied rate on the December contract currently resides at 4.49%.

Japanese Yen
Disappointing economic figures added to the glee of yen bears as industrial production for the world's second largest economy fell short of consensus estimates.  Expected to decline 1.1%, in line with the previous figure, the most recent data pointed to a 1.2% decline in the month of July.  As a result, sentiment still remains that the once touted economic recovery remains sluggish at best and may actually be momentarily questionable.  Contributing to overall skepticism has been recent declines in consumer spending and investment, although capital investment still remains supportive.  On the flipside, the continued rise in the benchmark Nikkei 225, setting fresh 4 year highs on the session, seems to be reflective of growing optimism of future gains by global foreign interests backed by brighter commentary by policy officials in recent days.  Additionally, one cannot forget the increasing probability of forthcoming financial reform in relation to yesterday's election win by Prime Minister Koizumi.  Combine all of these factors and you still have a hint of brighter things to come despite the recently weak economic figures.  Separately, released during the day were minutes from the Bank of Japan's monetary meeting on August 8-9th.  Although no rate changes were discussed, or even expected, board members remain steadfast in their watch for signs that would confirm the end of deflationary conditions in the economy.  Notably, however, two members elected to decrease the current 30-35 trillion yen liquidity target in order to ramp up activity, but were defeated yet again by the resounding majority.

Kathy Lien is the Chief Currency Strategist at FXCM.