US Dollar
With both the US and Canadian markets closed for Labor Day, trading has been extremely quiet in the US dollar against the Euro and British pound. However, the lull ends there as we quickly scan over to our Japanese Yen charts and see a sharp slide in the dollar against the Yen. The major focus of traders returning from their summer holidays will be the gradual changes that we have been seeing in the US economy and other financial markets over the last few months.  At the beginning of August, the Federal Reserve left interest rates unchanged.  This shift in monetary policy has been absorbed and priced into the market already, but what has not been fully priced in is the clear evidence of subsiding inflationary pressures.  Oil prices are now trading back below $70 a barrel and gasoline prices are beginning to follow suit.  We have seen forecasts that call for gasoline to fall below $2 a gallon by the end of the year.  Granted, the risk of a Hurricane could still drive prices higher once again, but so far, the path of least resistance for oil, is lower.  As energy prices drop, so will the pressure on the Federal Reserve to resurrect its interest rate hikes later this year.  We already mentioned yesterday that the probability of another quarter point move before the yearend is less than 20 percent.  In the week ahead, the primary driver for market activity will be the beginning of a new quarter and the return of full market activity. Economic data is light with no data due for release tomorrow and only the Federal Reserveââ,¬â"¢s Beige Book report and non-farm productivity on Wednesday.  The labor market is holding on strong, which could help to boost the outlook for the report by some districts, but recent evidence of a slowdown in the housing market should temper that.  This suggests that for the time being, the risks for the US dollar and the US economy are still continuing to grow.

Euro
The Euro is slightly firmer today thanks to a strong report on producer prices.  In the month of July, producer prices grew by 0.6 percent, driving the annualized pace of growth up from 5.8 percent to 5.9 percent.  As we suspected, inflationary pressures in the Euro zone must be very high for ECB President Trichet to be as hawkish as he was last Thursday.  If you recall, Trichet said that the central bank needed to exercise strong vigilance to ensure that inflationary pressures are capped.  Energy prices also remained very high throughout the month of July and did not fall until the month August.  The fear is that the growth in producer prices would trickle down to consumer. The ECB has a mandate to ensure that inflation stays close to and ideally below their 2 percent target.  The rise in PPI makes it much more difficult for them to contain that rate below their target without raising interest rates.  With the ECB extremely hawkish and the Federal Reserve neutral, the Euro could see more upside pressure.  However, if energy prices continue to trend lower or even remain at this level for the next few months, we expect the ECB to gradually tone down their hawkish stance.

British Pound
The British pound is stronger today as the CIPS PMI construction index soared to a 5-month high.  The index rose from 53.2 to 54.5 in the month of August, providing further evidence of the solid recovery that we have been seeing in the countryââ,¬â"¢s housing market.  The index was originally expected to drop slightly to 53.0.  This is a great way for the UK to start the third quarter as it is extremely positive for the economy.  The report does little to shift the Bank of Englandââ,¬â"¢s stance on interest rates, but it does set the British pound up for a strong week.  The UK has one of the busiest economic calendars next week.  We are expecting service sector PMI, retail sales, industrial production and the Bank of Englandââ,¬â"¢s monetary policy decision.  The BoE will be leaving interest rates unchanged after their surprise irate hike last month.  Confidence has already been dented somewhat by their rate hike, so it is unlikely for them to hurt it even further by delivering two back to back rate hikes.

Japanese Yen
The Japanese Yen is the dayââ,¬â"¢s strongest performing currency following a much larger than expected rise in capital spending in the second quarter.  Originally predicted to have increased by 14.5 percent, capital spending rose by 16.6 percent.  This is the second straight quarter of double digit growth which should lead to upward revisions to second quarter GDP, which is due for release next week.  The numbers indicate that the increases in corporate profitability have been used for plant and equipment investments.  The hope is that this will spillover to the consumer, which would eventually help to boost spending.  In order to do this however, what we really need to see increases of are wages.  Having appreciated significantly over the past few weeks, Yen crosses have also slipped significantly as well.  Aside from leading indicators, the Eco Watchers survey and a monetary policy report by the Bank of Japan, there is little else on the Japanese calendar in the week ahead.  This could lead to more unwinding of yen carry trades.  Meanwhile, also boosting the Yen is a report that Iran and Japan may be completing an oil deal together.  As a country that imports nearly all of its oil, a wider range of suppliers may make the country less sensitive to any shocks in oil prices.  However, this arrangement could also be concerning to the US politically which makes it a double edged sword for Japan.

Kathy Lien is the Chief Currency Strategist at FXCM.