• Dollar Trades Cautiously Ahead of FOMC
• British Pound Holds Onto Gains Thanks to Stronger Data
• Japanese Yen Rests Hope on Household Spending

US Dollar
It is not unusual to see trading be very quiet the day before a Fed meeting, especially one where the market is not all too certain about what the outcome may be.  Of course, a quarter point rate hike has been completely priced into the market so the actual interest rate adjustment should not be the market mover.  Instead, as has been the case for most of last year, the risk lies in the FOMC statement. There are two full months before the next Fed meeting, which means that a lot can change between now and March 28.  Greenspan will not only want to leave the Fed with the flexibility to respond to changing economic data, but also leave Bernanke the flexibility to do as he deems fit with monetary policy.  A sign of a more neutral statement would be if the Fed dropped the phrase "some further measured policy firming is likely to be needed" and puts further tightening more contingent upon economic data. If this is the case, although unsurprising, it would be taken as slightly dollar bearish because it fails to acknowledge the market's expectation for a 70 percent plus probability of a March 28 rate hike.  Even if the FOMC rate decision is a non-event, there is so much economic data due for release this week that it will be hard for the currency market to stick to range trading.  Personal income and spending for the month of December were released today and taking a look at the numbers, we see that spending grew twice as fast as income last month.  This trend is always worrisome to us since consumers continue to dip into their savings to fund their lavish spending habits, which is not a sustainable nor healthy fuel for growth.  Personal savings for the same month fell 0.7 percent to the lowest level since 1933, after decreasing 0.2 percent in November.  Core price inflation was a bit softer last month as well, rising only 0.1 percent, keeping the annualized pace of growth unchanged at 1.9 percent.  Aside from the FOMC decision tomorrow, there is also the consumer confidence figure.  The market expects confidence to jump to 105 from 103.6.  Perhaps it may, but we think that the risk is higher for confidence to weaken since energy prices have ticked up and the housing market is slowing, albeit modestly.   

Euro
Like the US, the big week in Europe does not begin until tomorrow.  The economic calendar was pretty much devoid of any significant economic releases, but tomorrow will be very different.  The Eurozone will be releasing unemployment numbers for both France and Germany, German retail sales, French and Italian producer prices as well as regional consumer and industrial confidence.  The economic environment in Europe has been improving and we expect this week's data to confirm that.  Slow but steady growth in the past and signs of good performance in the manufacturing sector suggests that the first quarter could be a good one.  This has even catapulted expectations for more hawkish comments from ECB President Trichet after their rate decision on Thursday.  The ECB is expected to keep rates unchanged, but after leaving out the word "vigilance" from recent comments, the market is looking for validation of the ECB's hawkish stance from Trichet once again.  Such expectations could limit losses in the EUR/USD this week, but as we all know, the dollar's sway on the markets is big, so if there are many major surprises US data wise, any support that hawkish comments from the ECB could bring for the dollar would be shrugged off relatively quickly. 

British Pound
In contrast to the price action in the Euro, the British pound managed to gain strength against the dollar today.  Improving house prices as well as a 2.3 percent jump in M0 money supply has some critics of the British pound thinking twice about calling for a first quarter rate hike this year.  With money supply growing at a time when oil prices are also rallying, upside inflation pressures will remain evident, especially since the market  only expected money supply to grow by 0.9 percent this month. The stability of the housing sector is still comforting since it was one of the most worrisome sectors for the Bank of England last year.  Going forward, as the BoE has brought up last week, business investments and exports are the current risks to the economy so that should be our new focus since they could play a larger role in impacting the central bank's decision on monetary policy.

Japanese Yen
Count it - we now have five consecutive days of gains for the dollar against the Japanese Yen. Of course, USD/JPY has been a trending currency pair over the past year, so it is not surprising to see trend extensions last for a while.   Even though consumer prices came in stronger late last week, the government's determination to prevent the Bank of Japan from removing the country's quantitative easing policy has capped gains in the Japanese Yen.  To top that off, industrial production increased a mere 1.4 percent in the month of December.  Though still positive, it fell short of the market's 1.8 percent forecast.  There is still hope for the Yen though this week.  Like many of the other countries around the world, the economic calendar is heavy.  Should household spending rise as strongly as they are expected to tonight (market forecast is positive 2.5 percent), then we may see our first retracement in USD/JPY in five days.  Meanwhile China announced over the weekend that the dollar makes up "much less" than 50 percent of China's currency basket. They also said that they do not intend to accumulate more foreign exchange reserves.  News such as this has only one implication for the US dollar and that is negative - so there is good reason to expect the USD/CNY pair to continue to sell-off in 2006.

Kathy Lien is the Chief Currency Strategist at FXCM.