• Oil Set to Weigh Down Dollar Tuesday
• Euro Weaker Following Softer Inflation Data
• Biggest One Day Gain in Dollar Yen in 2 Weeks

US Dollar
With the US markets closed for the Martin Luther King holiday, trading has been exceptionally quiet.  The dollar has been caught within a 30 pip trading range against the Euro as the market assesses what the new week may bring.  Weekend developments seem to point to the possibility of a bit more weakness for the dollar at the onset of Tuesday trading.  Tensions have continued to increase with Iraq as they warned of soaring oil prices if they are subjected to economic sanctions.  They have also put together a conference to discuss the truthfulness of the Holocaust and most recently, banned CNN journalists from working in the country after they misquoted the Iranian President.  As we have been warning recently, Iran does have the sway to push up oil prices.  As the world's third largest holder of oil reserves, Iran is really the only country left that has excess capacity to produce additional oil.  The only 2 countries that have more oil is Saudi Arabia, who is suspected to be already producing at full capacity and Canada, who's recently discovered oil sands will take a significant amount time to extract.  Iran on the other hand is only producing about 4 million barrels per day and is capable of increasing production by another 3 million barrels.  Therefore, Iran's threats are not just open threats.  If the situation worsens and Iran actually follows through with their words, $100 oil may not be out of the question and neither will $600 gold.  For the currency market, this could cause a great deal of volatility and would translate into strength for currencies like the Canadian dollar, Swiss Franc and Aussie.  Opening up the week with higher political uncertainty will make it more difficult for the dollar to rally even if Tuesday's US Empire State and Industrial production reports come out strongly.  With colder weather in the Northeast, there is good possibility of oil prices opening up much higher on Tuesday, which would be dollar bearish.  In all likelihood, any recovery in the dollar may not come until Wednesday, when we expect CPI, the Beige Book report as well as speeches from Fed President Bies and Lacker. 

Euro
The Euro is slightly weaker against the dollar today but much of that weakness came in the European trading session and not the US trading session.  Instead, the Euro quietly recuperated its losses after coming 3 pips shy of 1.2100.  Inflation figures out of Italy painted a very similar picture to that of the France last Friday.  Italian inflation growth for the month of December was confirmed at flat, while French inflation growth reported last week was a mere 0.2% (EU Harmonised).  Before jumping the gun on declaring that inflation has been tamed however, we still need to see tomorrow's German consumer price inflation reports.  Right now, the estimates are for higher inflation growth in the month of December.  Judging from the recent consumer price inflation reports released from the Eurozone and producer price inflation reports released from the US, the surprise will most likely be to the downside.  The big question is then if German consumer price inflation also comes in weaker than expected, will that deter the European Central Bank from raising interest rates this quarter.  The lack of the word "vigilant" in Trichet's press conference suggests that Trichet may have already had a first hand look at the data.  For the time being, a 25bp rate hike this quarter is still on track. 

British Pound
Unlike the Euro, the British pound took a deeper slide today.  Producer price inflation figures were mixed with input prices rising more than expected and output prices taking a surprise tumble.  The fact that producers are not passing their higher costs over to end-users is an unsustainable trend that poses a risk for the economy.  Input prices rose 0.9% while output prices fell 0.2%. Tomorrow's consumer price report should tell a clearer story, but the market has taken this to imply a greater likelihood of another rate reduction by the Bank of England.  Home price data released by the Office of the Deputy Prime Minister (ODPM) and online property site Rightmove both suggests that house prices are beginning to stabilize.  Although the ODPM report is relatively delayed (for the month of November), the Rightmove survey (for the month of January) is generally a good leading indicator for the trend of house prices.  As one of the sectors of the economy that the Bank of England watches most closely, we too will be looking for more evidence of stabilization. 

Japanese Yen
The dollar saw its best performance against the Japanese Yen today in 2 weeks.  Mixed economic data gave Yen bulls little direction as they bears stripped them of their gains.  Industrial production accelerated for the fourth consecutive month from 1.4% to 1.5% in the month of November, but at the same time the trade surplus increased from JPY1376 billion to a less than expected JPY1418 billion.  Export prices were flat in the month of December while import prices fell 0.4%.  The domestic consumer goods price index however increased 0.2%, bringing the annualized rate of growth to 2.2%, which is the highest in 15 years.  The lack of clarity left Yen traders will little to trade off of except for reports from the MoF that Y380 billion flowed out of Japan last month and rumors of more central banks snapping up dollars.

Kathy Lien is the Chief Currency Strategist at FXCM.