• Weaker Headline Payrolls and Comments by China Send Dollar Tumbling
• ECB and BoE Expected to Leave Rates Unchanged Next Week
• Blair Announces No Plans to Leave Office

US Dollar
After a one-day breather, dollar bears jumped right back into the markets to pound the greenback lower.  In fact, the dollar is now trading at the lowest level against the Euro in 2 months.  The confusing non-farm payrolls report cause quite a bit of volatility this morning with a knee jerk reaction higher in the EUR/USD when the headline number for December payrolls printed at 108k, which was 92k below expectations.  The currency pair quickly retraced when traders took a second glance at the report and saw the 90k upward revision for the month of November along with the drop in the unemployment rate from 5.0 percent to 4.9 percent.  Taking the revision into consideration, the number was pretty much in line with expectations which mean that there was no reason to be alarmed.  The manufacturing sector saw an increase of 18k jobs, which was the third consecutive month of positive gains for the sector.  Average hourly earnings also ticked higher by 0.3 percent or 3.1 percent annualized, which was the fastest pace of wage growth since March 2003.  With the details of the data far less concerning and inflation still prevalent, expectations for moves by the Federal Reserve remain intact, with at least one more rate hike expected at the end of this month.  The latest comments from China should warrant more focus than today's non-farm payrolls.  Coming back to haunt dollar bulls was talk of Chinese reserve diversification.  China announced yesterday that they plan on diversifying their reserves away from the US dollar and US treasuries.  China is the world's second largest holder of US Treasuries, which means that any diversification away from dollar denominated assets, could have grand ramifications.  Although they are not expected to make any quick or massive shifts, even gradual moves in an environment that is already becoming less and less favorable to the dollar, could certainly give dollar bulls another reason to jump ship.  On the bright side (for some), if China reduces its demand for treasuries or dumps them straight out, the flat yield curve could become steeper and return to normal. 

Euro
Another day, another batch of mixed Eurozone economic today.  Today, German industrial production fell by a more than expected 0.4 percent on a monthly basis.  However, the annualized pace of growth accelerated from 4.1 percent to 4.7 percent in November.  Eurozone unemployment remained unchanged at 8.3 percent while the OECD's leading indicator increased from 106.6 to 107.2.  Most of the reports released this past week were mixed but the bias is still to the upside.  The Euro has strengthened close to 3 percent or over 350 pips since the beginning of the year.  For an export dependent economy, continued strength in their currency is similar to receiving a dose of monetary tightening.  The higher the Euro goes, the more the Eurozone will have to struggle to extend its growth.  Given the recent trend of mixed economic data and the ECB's fear of instilling too aggressive expectations for monetary tightening, the central bank will probably pass up raising interest rates again next week.  Of the 22 economists surveyed by Bloomberg, none expect a rate hike.  We suspect the ECB will continue to watch the trend of data and give themselves at least another month or two to assess the health of the economy before raising rates again.  

British Pound
Tracking the gains in the Euro, the British pound skyrocketed today against the dollar, ending the week 520 pips higher.  The empty economic calendar gave the pound little to move off of.  The only development was politically.  Despite a drop in confidence and a recent legislative defeat in Parliament, Prime Minister Tony Blair vowed to stay in office for his entire third term.  There was recent speculation that he would be forced to leave sooner rather than later and as early as 2007.  He also publicly backed Gordon Brown as his successor.  Although this may be a blow to Brown's supporters who were expecting the Chancellor to move into office before 2009, Brown may find comfort to finally receive Blair's public endorsement.  With a solid reputation, barring any unforeseen circumstance, there is little likelihood that Brown will not be the next Prime Minister. 

Japanese Yen
Despite the lack of any meaningful economic data, the Japanese Yen strengthened significantly today. Although much of the move has been credited to today's US non-farm payrolls report, we think it has more to do with the China story.  Rallies in other Asian currencies have certainly helped to lift the Yen, but diversification away from dollar assets could mean diversification into Yen denominated assets.  Japan and Europe is China's third largest trade partners, which means that if China were to reinvest those funds elsewhere, Japanese government bonds or Eurozone bonds could benefit.  In the first week of trading, China has already taken more steps towards further revaluation.  Not only did they make the reserve comment, but they also launched OTC operations and opened the doors for foreign exchange market making by both domestic and foreign banks. 

Kathy Lien is the Chief Currency Strategist at FXCM.