US Dollar
Although the Empire State manufacturing index dipped, the US dollar failed to.  In fact, the dollar’s reaction to the manufacturing index was minimal as the market interpreted the drop to be more of a catch-up move to the weakness that we saw in the Philadelphia index last month than a leading indicator for weakness nationwide.  Furthermore, the price indicators increased in the month of January, indicating higher inflationary pressures. With producer prices due for release tomorrow and consumer prices on Thursday, inflation continues to be the market’s main focus.  Recent economic data indicates that growth prospects remain relatively healthy which makes inflation the only unclear aspect of the US economy.  The market is currently forecasting for softer inflation growth, which if validated, could lead to a correction in the US dollar.  Should it surprise to the upside however, we may see another test of the 1.2866 year to date low.  PPI is not the only noteworthy piece of data on tomorrow’s US calendar – we actually have a big day ahead of us. We are also expecting net foreign purchases of US securities, also known as the TIC data, the NAHB housing market index, industrial production and the Beige Book report.  The TIC is expected to be very strong and there is a lot of wiggle room in the data.  Even though analysts are forecasting for $75 billion increase, any flow in excess of $60 billion, which is slightly more than the same month’s trade deficit should be positive for the US dollar.  The Beige Book report should also confirm the strength that we have seen in the growth data.  The only potential negative is industrial production and PPI.  Producer price growth is expected to be softer in the month of December while the mixed readings in the individual PMI reports suggests the potential for less than stellar industrial production growth.  Meanwhile the rally in the US dollar today has been primarily driven by continued drop in oil prices.  Crude is trading at a fresh 19 month low after Saudi Arabia joined Nigeria in rejecting the call for more OPEC cuts. 

Euro
The Euro gave back all of its earlier gains on the back of oil related dollar strength.  The improvement in the ZEW survey was not enough to keep the market Euro bullish.  In recent months, analyst sentiment, which is what the ZEW survey measures has done a mediocre job of forecasting business sentiment.  In fact, in some ways it appears to be lagging the IFO report, which is the measure of business confidence.  The IFO hit a 16 year high last month while the ZEW report simply rebounded from the 13 year low that it dropped to back in November.  Therefore the rebound in January from -19 to -3.6 appears more likely to be a catch-up move to the improvement that we have already seen in the IFO.  The recent weaknesses in the Euro and the prospects for an end to the ECB’s tightening campaign along with the limited impact of the VAT tax increase are all reasons that have contributed to the rosier outlook by economists.  Tomorrow we have the Eurozone consumer price report and trade balance due for release.  Both are expected to be relatively positive for the Euro, but as usual, positive US data could easily offset any strength in the European reports. 

British Pound
The British pound’s reaction to the stronger UK consumer price report indicates that the market had completely discounted higher inflation after the central bank’s surprise interest rate hike last week.  This was a classic buy the rumor, sell the news type of reaction which could remain the theme in for the GBP/USD given the currency pair’s recent rejection of a key technical area.  Even though the UK is the only central bank to continue embarking on a relatively aggressive tightening cycle, the market may begin to question whether the follow-up move will come in February or March.  With incoming housing data suggesting the potential of a mild slowdown, the central bank may be tempted to give the economy some time to absorb the hike before it delivers another one.  This comes after the RICS house price index came out softer than expected.  Prices fell to a 4 month low as the agency reports that the 2 rate hikes in 2006 have started to cool the housing market.  This is not the first piece of data that suggests a possible slowing.  According to the UK’s largest mortgage lender HBOS Plc, house prices declined for the first time in six months in the month of December. 

Japanese Yen
The Japanese Yen continues to fluctuate based upon speculation about what the Bank of Japan will do on Thursday.  A TV news report has been saying that according to their sources, the BoJ will refrain from hiking this week.  There are no shortages of rumors, but judging from the comments from Japanese government officials, we continue to stick to our belief that the BoJ will raise rates by 25bp but temper the market’s reaction to that move by signaling that another rate hike may be a long way off.  With the Yen weakening significantly against the US dollar, Euro and British pound over the past few weeks, the Japanese government appears to be backing off of the BoJ.  Chief Cabinet Secretary Shiozaki said last night that “interest rate decisions are the responsibility of the BoJ” while Finance Minister Omi said that it is “not the time for the government to seek a BoJ vote delay.” Yomiuri news is probably the most accurate in speculating that the government is unlikely to ask the BoJ to postpone its vote, which would confirm our view. 

Commodity Currencies (CAD, AUD, NZD)
The commodity currencies are all weaker across the board today as commodity prices tumble.  Oil is the biggest mover as the prospects of an emergency production cut from OPEC diminishes.  The Bank of Canada also left interest rates unchanged at 4.25 percent today.  The statement was balanced with a tinge of hawkishness as the central bank recognizes the slower growth experienced last year and projects a recovery in both growth and inflation in 2007.  Meanwhile New Zealand reported much stronger than expected Q4 business confidence.  Unfortunately we have not seen much strength in the kiwi as traders look ahead to a potentially weaker consumer price report this afternoon.  The drop in oil prices during the fourth quarter and the 8 percent rise in the New Zealand dollar against the US dollar should contribute to the overall drop in inflationary pressures.

Kathy Lien is the Chief Currency Strategist at FXCM.