US Dollar
This week is make it or break it week for the US dollar. The foreign exchange market has turned very dollar bullish after a series of upside surprises in economic data, causing a sharp plunge in rate cut expectations. The Fed funds curve is now pricing in steady rates for the first half of the year and slim chances for even one interest rate cut by December. However, these expectations can turn on a dime, just like they have over the past few weeks. We have a lot of very important data due for release this week and they can either make it or break it for the dollar by fueling more gains or causing a reversal. The main releases that we are watching include the FOMC statement, Gross Domestic Product (GDP), the Institute of Supply Management Manufacturing survey (ISM) and Non-Farm Payrolls (NFP). Each report will build on the next to help us gage how the ISM report and non-farm payrolls, which are the two most market moving indicators for the US dollar will fare. We start the week off with the Conference Board’s consumer confidence report tomorrow morning. The Conference Board report is far more reliable than the University of Michigan consumer confidence survey because it polls a larger group of people. Consumer optimism is expected to hit the highest level since May 2002 thanks to falling gasoline prices, low jobless claims and a stock market that is hovering near record highs. The 3 year high reported by the University of Michigan survey earlier this month also suggests that tomorrow’s report will be dollar bullish. If confidence proves to be as strong as the market expects, it will set the tone for the week by signaling a strong GDP report and a hawkish FOMC statement on Wednesday. However if confidence slips below December’s level, traders will begin to question the continued resilience of the US economy and will punish the US dollar as a result.

Euro
Demand from central banks as well as continually hawkish comments from European Central Bank officials have helped to prevent the EUR/USD from making a new year to date low. ECB President Trichet added credibility to the hawkish comments made by a number of his monetary policy committee members since the last ECB meeting. This weekend in Davos he said that the “fastest money supply growth in 17 years validates the recent rate hikes” and looking ahead there is still a risk that the recent rebound in oil prices could lead to an inflationary spiral. This morning, ECB member Liebscher added that the ECB has to act preemptively which indicates that the central bank is sending a clear message to the market about their plans to raise interest rates again this quarter. In fact, depending upon how aggressive oil prices rebound, the ECB could even deliver an interest rate hike in February. As for central bank demand, last Friday, Russia reiterated their plans to diversify their reserves into the Euro, Sterling and Yen at the expense of the US dollar. Aside from Russia, there is speculation that many central banks have orders to buy Euros below the 1.29 level. Looking ahead, manufacturing PMI reports from various countries within the Eurozone are due for release along with the German consumer price index. The increase in the Value Added Tax is expected to weigh on manufacturing sentiment, but our main focus will be on the expected increase in the annualized CPI growth rate to 2 percent, which would be back to the ECB’s target level. This should increase the pressure on the central bank to raise rates.

British Pound
The British pound underperformed both the US dollar and Euro after Bank of England monetary policy member Blanchflower said that inflation could fall back below the BoE’s 2 percent target by the end of the year as slack in the labor market pushes wage growth lower. Although Blanchflower typically sides with the doves, which means that he prefers looser monetary policy, his comments added salt to wound after the minutes from the latest BoE meeting revealed that the surprise rate hike was supported by only a small majority. The clear hawkishness of the ECB and the strong possibility that the Federal Reserve monetary policy statement will also be hawkish later this week has led the market to shrug off the solid CBI distributive trades number reported earlier this morning. The retail sales gage jumped from 25 to 30 while the expectations index surged form 4 to a two year high of 22. This strength indicates that the retail sector is still holding up the economy which suggests that the central bank could still raise rates in March or April.

Japanese Yen
Weak retail sales has sent the Japanese Yen plunging against the majors. Domestic spending has long been one of Japan’s biggest problems because even though corporate profitability has increased, there has been minimal wage growth. We now have evidence supporting the Bank of Japan’s decision to leave interest rates unchanged last month. There has not been enough growth in both consumer spending and consumer prices to justify tighter monetary policy. In fact, had the BoJ raised rates, they may have jeopardized the country’s fragile recovery. Even though European officials have been calling for some action to stem the Yen’s slide against the Euro, we do not expect much criticism about the currency’s weakness at the G7 meeting. The USD/JPY rate is not worrisome enough for the US to back the claim of European officials. Treasury Under Secretary Adams has already hinted that this will be the US’ stance when he said their cautious economic policy seemed appropriate. Furthermore, the weak growth in Japan validates the government’s need to keep the Yen weak.

Commodity Currencies (CAD, AUD, NZD)
The drop in oil and gold prices today forced the Australian and Canadian dollars to shrug off stronger business confidence. According to the National Australia Bank, business confidence rebounded from 2 to 4. In Canada, the survey of manufacturing conditions increased from -6 to -5. Business conditions moved back to positive while wage growth accelerated. However, neither of these reports will shift the monetary policy outlook of the Australian and Canadian central banks as both remain solidly neutral for the time being. The New Zealand dollar on the other is holding steady thanks to a slightly more hawkish central bank and the prospects for a smaller trade deficit in the month of December.

Kathy Lien is the Chief Currency Strategist at FXCM.