• Dollar Sells off on Fear That Fed Will Change Language
• Euro Rallies on Talk of Dollar Reserve Diversification
• Pound Shoots Higher on Stronger PPI Data

US Dollar
Traders took the dollar lower today on fears that the Federal Reserve may be making significant changes to their FOMC statement tomorrow afternoon.  For the eighth time this year, the Fed is expected to raise interest rates by 25 basis points to 4.25 percent.  As had been the focus of the past, the market will be paying more attention to the accompanying statement rather than the near guaranteed move.  According to the minutes from the November meeting, members of the Federal Reserve had believed that "several aspects of the statement language would have to be changed before long, particularly those related to the characterization of and outlook for policy."  The markets are looking for two possible changes * either the Fed drops the word "measured" or tweaks the "accommodation" statement by saying that after their December rate hike, policy is only slightly accommodative.  If either change is indeed made, we could see the dollar continue to sell-off.  However, with only one more interest rate meeting after this one that he will be chairing, Greenspan may instead choose to play it safe and pull for an unchanged statement until January, after which it becomes Bernanke's problem.  This may not be too hard to pull off, especially since the differing views within the FOMC may make it difficult to agree on what changes should be made.  However, before the market fully shifts into FOMC mode, we do have retail sales due for release at the beginning of the US session.  Sales are expected to rebound, but stripping out the automobile component, it is predicted to be unchanged, which means that the release may still bring a bit of uncertainty.  Meanwhile, the market completely shrugged off the November budget deficit figure, which hit a record of -$83.1 billion.  Spending related to Hurricane Katrina as well as higher interest payments both pushed costs higher by 15.3 percent year over year.  With the deficit having been a concern for some time now, the market seems to be giving more priority to unknown events this upcoming week. 

Euro
The Euro broke higher against the dollar today following comments from People's Bank of China adviser Yu Yongding who said that China and other Asian countries may be looking to reduce their dollar denominated reserves or at least slow the rate of accumulation.  More specifically, he called for more changes to China's foreign exchange regime, such as a further widening of the trading band and a cut in the dollar's percentage makeup in the CNY FX basket.  Reserve diversification is an age old topic that we have been talking about for some time now and a topic that fell to the sidelines after China moved to a weighted basket.  With the Euro beginning to turn, topics of the past should begin to resurface as traders or economists look for justification for the dollar's sell-off.  Concerns such as the US' record budget deficit, and central bank reserve diversification could all be factors that will be brought up.  Ultimately, even though recent ECB speak has confirmed to the markets that the central bank has no intentions of following in the Fed's footsteps by beginning their own aggressive rate hike campaign, the market is looking for the ECB to continue to hike rates in the year ahead.  Meanwhile with the US, traders have become complacent with rate hikes and are actually watching the Fed very closely for signs of when they will stop raising interest rates. 

British Pound
The British pound shot higher for the third consecutive trading session, erasing the past two months of losses as producer prices increase more than expected.  Input prices increased 1.4 percent in the month of November as output prices fell 0.2 percent.  This is the second month that we are seeing producers bear more of the higher cost than their end users.  This trend cannot continue forever.  Tomorrow's consumer price report should be a bit more telling as to whether the growing costs have hit the pocketbooks of consumers at all.  Also helping to bolster the pound today was the improvement in the CBI's survey of the manufacturing sector for the month of December.  The total orders index increased from -25 to -22 despite a slide in export orders from -13 to -23.  With the index still negative, the manufacturing sector is far from healthy and the UK economy has yet to fully stabilize.  The central bank should still be watching the housing sector very closely for signs of a renewed downturn.  The ODPM reported today that growth in house prices moderated to 2.2 percent y/y in November from 3.3 percent in October. 

Japanese Yen
These days, the true direction in the Japanese Yen is being reflected more in the trading of the Yen against the crosses than the Yen against the dollar.  Taking a look at today's price action, we saw the Yen trade lower against the EUR, CHF, and GBP but higher against the USD.  Japanese economic data released overnight was mixed to negative with the trade surplus shrinking and the prices of consumer goods falling, while consumer confidence rebounded.  Japan has been struggling to recover and the recent rebound in oil prices is certainly not helping.  Against the dollar however, the Yen has rallied, which confirms that the currency pair's price action is primarily driven by dollar factors and not yen factors.  USDJPY is still one of the most attractive carry trades of 2005, but with the fear that the Fed may be softening the tone in the FOMC statement tomorrow, traders are treading very carefully.  Comments from PBoC adviser Yu also helped to bolster Yen gains as a reduction in the dollar's share of the basket could possibly mean an increase to the Yen's share.  This is especially true since China is now Japan's largest trading partner and Japan is China's third largest trading partner. 

Kathy Lien is the Chief Currency Strategist at FXCM.