• Dollar Treads Carefully Ahead of Payrolls Friday
• Hawkish Comments from ECB and BoE Boosts Euro and British Pound
• Yen Weakens on Dovish Comments from BoJ Muto

US Dollar
Profit taking in the dollar today ahead of tomorrow's non-farm payrolls report has helped the EUR/USD recuperate approximately 50 percent of yesterday's losses.  Today's labor market data points to a strong payrolls report, but with analysts over forecasting payrolls five times over the past year and under forecasting them seven times, the odds are that we will be seeing yet another surprise.  Jobless claims for the week ending January 28 fell by 11,000 to 273,000, pushing the four week average to the lowest level since June 2000.  Continuing claims also fell to the lowest level since February 2001. Outplacement firm Challenger Gray & Christmas reported a 4 percent drop in corporate layoff announcements between December and January while the Monster.com Employment index hit all-time high of 151.  So given the lofty consensus expectation, what is the risk for the dollar?  The market has already priced in the possibility of a March 28 rate hike, which means that a strong number should only boost the US dollar modestly since an additional rate hike to 5.00% in May at this point is a bit far fetched.  This means that even though we would see a dollar rally on a 250k plus number, depending upon the size of the surprise, the sell-off in the EUR/USD could be limited to 1.1970.  Alternatively, the market's expectation is tipped so deep to the favor of a strong release that if payrolls come out below 175k, we could easily see the EUR/USD rally back above its 200-day SMA resistance at 1.2150.   

Euro
The Euro rallied as European Central Bank President Trichet talked up the need to for tighter monetary policy.  Introducing back a word that he left out at the previous meeting, Trichet said that high energy prices, an improving housing market and rising credit growth required the ECB to demonstrate "vigilance" by keeping a lid on inflation.  So it seems that the recent downturn in data has not worried the ECB and in fact, Trichet believes that "conditions remain in place for continued growth" and that "consumption should pick up." He called the market's expectation of interest rates "reasonable."  For many this "market expectation" comment refers to the originally forecasted first quarter rate hike.  If Trichet had not downplayed weaker data and renewed his hawkish stance, the market would have pushed out their forecast for another rate hike to the second quarter.  Now however, we could very well still see a March rate hike and the shift in expectations is expected to jostle the market. The rally remains contained at the moment because of the event risk tied to the US non-farm payrolls report.  However once that is out of the way and dependant of course on a neutral or weaker non-farm payrolls release, this could pave the way for a resumption of the EUR/USD's rally. 

British Pound
The British pound traded higher against the dollar today but gains were capped ahead of the US non-farm payrolls release.  The CIPS Construction sector purchasing managers' index was the only economic release on the calendar and despite the decline from 52.6 to 50.7, traders remained bullish as Bank of England Governor King reassured the markets that economic growth has recovered and is close to a sustainable rate.  After a series of positive economic data released earlier this week, the market had already shifted expectations for a second quarter rate cut instead of a first quarter cut at the earliest.  Today's comments suggests that the Bank of England may not even cut interest rates at all this year, which if really is the case, would be extremely positive for the British pound. 

Japanese Yen
The dollar continued to charge forward against the Japanese Yen as carry traders become even more confident that Japan's zero interest rate policy is here to stay for a while longer.  Bank of Japan Deputy Governor Muto said that even if the BoJ decides to exit its quantitative easing policy, interest rates will remain at zero for a few months.  In an environment with growing US interest rates and flat Japanese rates, USD/JPY has remained extremely well bid.  Unfortunately this also detaches the performance of the Japanese Yen from the performance of Japan's economy.  If you recall, over the past week, economic data has suggested increasing economic activity.  Household Spending increased 3.2 percent year over year in the month of December, indicating that domestic demand may be finally contributing to growth.  The jobless rate also fell from 4.6 percent to 4.4 percent while the purchasing manager's index jumped from 55.7 to 57.0, the highest level on a record.  Consumer price inflation also ticked higher.  However the persistence of the Japanese government to talk down the possibility of rate hike has stifled gains in the Yen.  Clearly the Japanese government and its officials have an agenda to keep the Yen weak and monetary policy stimulative.

Kathy Lien is the Chief Currency Strategist at FXCM.