• Dollar Shifts Gears to Focus Back on Fed
• Pound Rebounds Despite CPI Downtick in Annualized CPI
• Yen Slides as Oil Prices Rise and Nikkei Tumbles

US Dollar
The US dollar strengthened against the Euro in the early European trading session but spent most the US session giving back those gains.  Overall, trading has been very quiet as the EUR/USD continues to fluctuate within 1.2010 and 1.2180 as it holds above the January 3rd breakout high.  Consolidation has remained the theme, but with the large amount of important data due for release tomorrow, this could all change.  We are expecting the consumer price index, the Treasury International Capital flow report (also known as net foreign purchases) and the Beige Book report.  Each one of these could independently move markets, but having all three together in one day means that we have all the ingredients for a breakout move.  Focus tomorrow should be turning to the Federal Reserve meeting on January 31st.  Although another quarter point rate hike has been fully priced in, the market will be looking for signs of whether the accompanying FOMC statement could take another shift towards neutral.  Both the Beige Book and the CPI report will play a major role in setting market expectations.  Right now, the market is pricing in a 60 percent probability of another rate hike in March.  In which direction the dollar will break out is still not clear as the US economy faces growing risks.  If weakness is cited by the various Federal Reserve districts, we could easily see the EUR/USD trade back above the 1.2150 level.  However, much is also contingent upon how the TIC data performs.  Expectations are for inflows to have increased by only $85 billion in the month of November, down from $106.8 billion.  Yet, after back to back triple digit gains, $85 billion worth of inflows is still significant.  The market will only become concerned about US funding needs and the trade deficit if flows came in below $55 billion for the month. Meanwhile today's economic releases were mixed, giving the dollar little direction.  The Empire State manufacturing index for the month of January fell from 26.3 to a less than expected 20.1, while industrial production for the month of December accelerated by a more than expected 0.6 percent.  Capacity utilization also increased from 80.3 percent to 80.7 percent, the tightest level of capacity since November 2000.  Despite the conflicting manufacturing reports, the sector is still gradually improving.

Euro
The Euro quietly recuperated its losses during the US session on more speculation of central bank buying.  Despite dropping off of the headlines, reserve diversification continues to remain a predominant  theme on trading desks.  Oil prices are also higher and back above $65 a barrel, which may be helping the EUR/USD recover.  German inflation numbers were slightly stronger than expected with the consumer price index rising 0.9 percent last month after falling 0.5 percent the previous month.  EU harmonized CPI also increased 1.0 percent, bring the annualized pace of growth to 2.1 percent.  Italian numbers were not as encouraging however as industrial production increased a paltry 0.1 percent against market expectations for a 0.8 percent rise.  Italy seems to be lagging in terms of growth recently, which is slightly inconsistent with bullish comments from ECB member Tumpel-Gugerell who reiterated that the outlook for growth is optimistic but inflation expectations are under control at the moment.  Although we do expect the ECB to increase interest rates a few more times this year, their less hawkish outlook on inflation is quite interesting.  If the EUR/USD continues to rise and inflation remains under control, the ECB could feel less compelled to increase interest rates since looser monetary policy will help to offset some of the economic tightening brought on by a strong Euro.  However, with oil prices aiming for $70 a barrel once again, the ECB's nonchalant perspective on inflation may be temporary. 

British Pound
The British pound staged a strong recovery to end the trading day virtually unchanged.  After seeing the bearish undertones in yesterday's PPI numbers, rate cut speculation is back on the table as consumer prices fall back to the central bank's 2.0 percent target.  The third consecutive decline in gasoline prices and more discounting by airlines dragged the overall index lower.  However, despite the downtick, central bank governor Mervyn King warned that inflation could still rise and he believes that it will not be easy to keep inflation close to the 2 percent target.  Also adding to the British pound's recovery is speculation that tonight's RICS house price report could be particularly strong.  Recent data has been pointing to stabilization in the housing market.  If this is really the case, then the BoE has an even less compelling reason to cut rates next month.  Whether this is true or not, what is most important is that with the quarter point rate hike expected from the Fed at the end of this month, the pound's carry advantage over the dollar will completely evaporate. 

Japanese Yen
For the second straight day, the dollar extended its impressive rally against the Japanese Yen.   The weakness in the Yen was due to a combination of confusing economic data and a sharp tumble in the Nikkei.  Headline consumer confidence in Japan fell for the first time in three months from 48.2 to 46.7.  However, seasonally adjusted consumer confidence actually improved from 44.8 to 48.2, which is the strongest level of confidence in 15 years.  Meanwhile the Nikkei tumbled by the largest amount in 9 months following news of a potential securities violation by a Japanese high tech firm.  The resignation of Taiwan's Premiere has also weighed on Asian markets while higher oil prices have directly pressured the Japanese Yen.   With oil prices just a stones throw away from the previous high above $70 a barrel, Japan, who imports the majority of its oil at the biggest risk.

Kathy Lien is the Chief Currency Strategist at FXCM.