• Watch Out - Hawkish Comments Expected from ECB
• Dollar Balances Increased Geopolitical Risks with Retraction of Chinese Comments
• British Pound Holds onto Gains Thanks to Strong Retail Sales Data

US Dollar
The US dollar's performance this week is shaping up to be very different from last week, when we saw the dollar sell off across the board against the majors.  Today, the dollar strengthened against all currencies expect for the British pound and the Japanese Yen.  In fact, no one currency has seen a clearer trend against the dollar with virtually no retracements than the Yen.  Carry trade liquidation remains the predominant theme, which also goes to show the importance of interest rates for the year ahead.  The dollar's mixed performance has to do with two conflicting global developments.  Geopolitical risks remain on the forefront as Iran defies the United Nations by breaking their seals and restarting their nuclear program.  With the mounting possibility of this becoming a deeper crisis, oil prices have remained solidly above $60 a barrel.  As OPEC's second largest producer, Iran knows that its world critics will tread carefully because any sanctions on their number one export, oil, would only further raise the price of oil, which would undoubtedly affect the world economy.  On the flip side, helping to contain dollar bearishness were new comments from China.  Unsurprisingly, China has come back to “reclarify” their recent comments on reserve diversification. This seems to be something they do quite often - which is introduce an idea, watch the market react and then take back their comments if the reaction is excessive or undesirable. Previously, they have said that they were looking to diversify out of dollars.  Today, they said that their comments were not directed at current reserves but may be considering options for new reserves. One way or the other, there is no doubt that central banks in Asia have seen increasing foreign investment.  UBS announced today that they downgraded their one and three month targets for the US dollar.  They blame the expected weakness on deterioration in the US trade balance, increased uncertainty, central bank diversification, and properly priced equity and bond market valuations.  Nothing new, most analysts have been calling for the same thing - slower US growth, higher oil prices and lower house prices.  What they don't quite agree on yet is whether the Fed will stop at 4.25%, 4.50% or 5%. 

Euro
Another trend that we have been seeing is stronger Eurozone economic data.  The German ZEW index jumped from 61.6 to 71, which is the highest level that we have seen since January of 2004. The Eurozone ZEW index increased from 51.2 to 66.1. More investment is occurring in the Eurozone and we are beginning to see economic recovery that may very well be fueled by more than exports alone.  Yesterday's larger trade surplus already illustrated this possibility which as we have said will become even more important as the Euro continues to rise.  French and Spanish manufacturing activity also improved with industrial production increasing by 3.1% and 0.8% respectively.  Overall, the evidence continues to stack up in favor of another rate hike by the European Central Bank.  If the current trend continues, it will be a move that the ECB cannot avoid.  In the shorter term however, even though the ECB is not expected to raise interest rates on Thursday, there is a very good possibility that we will hear some hawkish comments from ECB Trichet, which could help the Euro regain some upside momentum.  Meanwhile, the Avian flu epidemic is still hitting headlines. There are 15 people in Turkey who have tested positive for the virus while Greece is on alert for contamination.  For the time being, there have been no human to human transmission, but it is at least a reminder that it may be too early to forget about the Avian flu virus. 

British Pound
Strong retail sales has helped the British pound hold onto its gains against the dollar.  Retail sales jumped by 2.6%, the largest amount in 18 months and double market expectations.  December has proved to be a great month for retailers which going into Thursday's Bank of England rate decision only further solidifies the already consensus expectation that the BoE will refrain from lowering rates once again.  Recently, we have seen more people jump over to the neutral camp from the rate cut camp.  Economic data has been very mixed which certainly doesn't help the BoE's decision making process.  Even though the retail sector has been improving, the manufacturing sector has been soft.  The Trade Congress Union called for another rate cut as higher unemployment and lower growth could be a big risk for the sector.  As we stand, the BoE is still on rate cut watch, but in the past week, they have certainly inched closer to neutral.

Japanese Yen
The Japanese Yen strengthened significantly against all of the majors expect for the Canadian Dollar.  Household spending was weaker than expected and Economic Minister Yosano warned about excessive fluctuations, but both did little to stifle the Yen's gains.  The trading range remains tight as traders mull over the possibility of another move lower.  Traders are taking the central bank comments with a grain of salt since the likelihood of Japanese intervention still remains low.  According to our proprietary sentiment index, more losses could be in store for USDJPY.  For the time being, most traders are still favoring a downside bias the currency pair.

Kathy Lien is the Chief Currency Strategist at FXCM.