• Dollar Extends Weakness on Talk of Reserve Diversification
• Euro Rises to 2 Month Highs
• Strong UK Data Boosts the British Pound

US Dollar
After yesterday's strong move in the currency market, the dollar extended its weakness against the majors today.  With no significant economic releases on the calendar, talk of reserve diversification has once again resurfaced.  We have repeatedly said that this topic will be a sore point that hangs over the dollar and something that the market will revisit in the months if not years to come.  Earlier this morning, a member of the Chinese Parliament speaking at a conference in Dubai said that the central bank of China should gradually reduce its US Treasury holdings.  Although the Chinese government quickly came out to do damage control by playing down the comments as simply the view of that official only, later comments by the central bank of Qatar indicating that they may be buying more Euros puts to question whether the other major central banks really do not have the same thought in mind.  Despite last week's hawkish FOMC statement, the market is still doubting the Fed's optimism.  However as much as we have been warning about the risks for the dollar, the recent move has been very strong and the EUR/USD is now reaching some critical levels on the topside which means we could see some stalling before a continued move higher.  The non-manufacturing ISM index is due for release tomorrow.  Even though the forecast is for a dip, the service sector has been performing far better than the manufacturing sector on average over the past two years which means that even though yesterday's ISM number came in bad, tomorrow's report could avoid following the same fate.  Finally, a popular newsletter report predicted the Federal Reserve to stop raising interest rates after the May rate hike.  Although two more rate hikes seem to be the consensus, the report is still worth noting since it is closely followed on the institutional level. 

Euro
The Euro jumped 1.1 percent against the US dollar today to the highest level in 2 months.  In fact, it is now less than 100 pips away from its year to date high.  Unemployment and producer price numbers were both in line with expectations which mean that it had little impact on the EUR/USD.  The data does however show that the unemployment outlook is improving with the unemployment rate dipping from 8.3 percent to 8.2 percent.  Tomorrow should be different however since are expecting retail sales and service sector PMI for the entire region.  These reports should cement expectations for how hawkish the central bank could be on Thursday.   Growth in retail sales are expected to be flat, which could come as a disappointment to some.  For the most part, the market is expecting hawkish comments on Thursday given the recent comments by central bank officials.  Therefore, if Trichet fails to deliver, we could see a sharp pullback in the Euro.  Meanwhile over in Switzerland, consumer prices fell 0.1 percent last month.  This comes as a surprise since the market was expecting prices to tick higher by 0.2 percent, which would solidifying expectations that the Swiss National Bank will continue to raise interest rates a few more times this year. 

British Pound
The British pound joined in the rally today, rising 0.9 percent against the US dollar.  The construction sector PMI report came in stronger than expected, confirming continued stabilization in the housing market.  The index rose from 51.9 to 54.7 which is the highest level since September of last year and adds to fuel to those who believe that the central bank will continue to leave interest rates unchanged for the remainder of the year.  Mergers and acquisitions also bolstered the British pound.  Last month, there were a great deal of sterling positive announcements and today we have talk of Prudential PLC possibly being sought for acquisition by a US company.  Tomorrow we should move away from focusing mostly on dollar driven reports and rumors to movements based upon more concrete economic data.  Industrial production, service sector PMI and the BRC shop price index are all due for release.  Taking a look at the forecasts, it seems that the market is expecting a batch of weaker numbers. If so, we could see a nice retracement in the GBP/USD. 

Japanese Yen
For the most part, USD/JPY has been trapped in a very tight trading range, making some sort of major breakout seem imminent.  The Japanese Yen strengthened against the US dollar but weakened against all of the other major currencies.  The Yen benefited a bit from rumors of reserve diversification, but for the most part consolidation remains the predominant theme.  There is talk that a strong stock market as well as the prospect for higher yields could make Japanese investments more attractive.  The economic calendar is fairly light for Japan this week which means that any breakout that we see in USD/JPY will most likely be driven by dollar factors rather than yen factors.

Kathy Lien is the Chief Currency Strategist at FXCM.