• Dollar Rallies on Expectations that Fed will Deliver Another Quarter Point Rate Hike
• Euro Traders Zero In on German Elections
• Dollar Yen Breaks Higher on Greenback Strength

US Dollar
It has been an exceptionally strong week for the dollar.  The greenback has managed to gain strength against most of the major currency pairs despite a batch of mixed economic data.  Over the past week, we learned that inflation, particularly core inflation for the month of August was much softer than expected, suggesting that the rise in energy prices may actually have a deflationary affect on the prices of other products.  Headline retail sales, industrial production, jobless claims, consumer confidence, and the manufacturing sector surveys from the Philadelphia and NY region all pointed to weaker conditions in August and September.  It was the more backward looking or delayed releases such as the trade (July) and current account balance (Q2) as well as the Treasury International Capital flow report (July) that exhibited signs of strength.   The market however has chosen to focus on the older data this week rather than the more current ones, leading to a 210 pip rally in the dollar against the Euro.   With no significant data releases due out of the US on Monday, the FOMC rate decision on Tuesday afternoon has the market's undivided attention.  At this point, a quarter point rate hike to 3.75% is a near certainty.  Of the 1130 people who participated in the DailyFX interest rate poll, only 10% of the respondents expect interest rates to remain at 3.50% at year end, while 40% expect interest rates to be increased only 2 more times this year.  As we have previously mentioned, the Federal Reserve is probably in "information-gathering" mode as they assess how much of an impact Katrina has on US jobs and the economy as a whole.  Meanwhile, the economic data released this morning was very mixed.  The current account deficit and the University of Michigan consumer confidence number both came in worse than expected.  Yet the sharp rise in net foreign purchases of US assets negated any pessimism.  The market had anticipated foreign purchases of US assets to increase by $60 billion in the month of July but instead, it increased by a whopping $87.4 billion. This is more than enough to fund the same month's trade deficit of $57.9 billion and should relieve any fears that foreign demand is waning.  It is important to note that the strong inflows were primarily from the private sector and public.

Euro
Weak data released overnight has the euro struggling to gain strength.  The French current account deficit increased three times the amount expected while industrial production growth for the Eurozone slowed in the month July.  However the elections in Germany is the pain focus this weekend and could potentially set the tone for trading on Monday.  The race between Schroeder and Merkel's parties are extremely close and with the elections in Dresden postponed for at least another 2 weeks, political uncertainty in the Eurozone's largest country could remain for several more weeks.  The current belief is that if the centre right parties fail to capture a majority, we could see the Euro extend its recent slide. 

British Pound
Adding to notions that interest rate cuts may be a foregone notion, contrary to yesterday's retail sales data, were statements released by Bank of England policy maker David Walton.  Yesterday's retail sales, relatively unchanged after declining 0.6 percent in the previous month, sparked speculation of interest rate cuts as consumer spending remains sluggish at best with retailers struggling to keep market share and individual demand alive.  However, the slowdown in consumer spending may not be as cursed a notion as some may consider.  According to Walton, although individual consumption remains "subdued" amid rising energy costs and sliding housing valuations, it may indeed curb current inflationary pressures that have been driven to an eight-year high.  Annual inflation rose to 2.4 percent in August, above the central bank's 2 percent benchmark target.  Additionally, the policy maker added that the current rate of price increases should be "kept in perspective' with oil shocks being temporary and the effect limited on future wage growth.  In line with similar statements by Mervyn King, the statements suggest that although central bankers remain hawkish, consumer spending does remain a consideration on near term rate decisions with a realization that current energy spikes can be considered temporary shocks.  However, as mentioned before, the effects of energy prices still remain questionable as we head into the fall and winter season.  Notably, both seasons are known to drive prices higher.

Japanese Yen
With a lack of economic data today, traders bid the yen lower as interest shifted towards its greenback counterpart throughout most of the session.  However, as we close the overall week, optimism still remains lofty in light of relatively weak economic data, i.e. dips in industrial production and overall household spending compared to incremental increases in consumer confidence.  The key here contributing to overall optimism looks to be stemming from central bankers' suggestions as well as mounting foreign interest, that things may significantly turn for the world's second largest economy.  Notably, this interest looks to be reflected in recently exploding investment capital in Japanese equities.  Subsequently, the Nikkei has vaulted higher through the 12,000 level in a matter of months and now remains slightly below after testing the 13,000 figure.  This leaves the benchmark index higher by almost 13 percent for the year, adding to yen strength.  Additionally, with financial reform on the way, consumers may be ready for another bout in underpinning overall expansion as Vice Finance Minister Koichi Hosokawa calls on the central bank to maintain an "appropriate" monetary policy.  Ultimately, the only fear that remains is a further rise in energy prices.  With oil prices calmer on OPEC demand forecasts today, further near term waning crude interest will likely see uninhibited interest in the yen against the current staid range that is being witnessed.

Kathy Lien is the Chief Currency Strategist at FXCM.