Dollar Strengthens Ahead of FOMC as Weaker Growth Takes Backseat to Stronger Inflation Pressures
The US dollar has strengthened ahead of the FOMC meeting despite the larger than expected drop in durable goods orders in the month of May. The US economy is clearly facing problems as the weakness in durable goods follow disappointments in both existing and new home sales. However, the problems in the economy will take a back seat to inflation risks at tomorrow’s FOMC announcement. Consumer and producer prices were both up in the month of May and based upon the recent increase in corn and dairy prices as well as the mild change in the US stock market, the Federal Reserve is not likely to loosen their leash on inflation. Oil prices also jumped over 1 percent today after reports of lower US fuel supplies. Crude prices are now $1 shy of its 9 month high. At this point, the Federal Reserve does not have much choice other than to keep the tone of the statement unchanged in order to tame the stock market bubble. The key phrases to watch are the ones in reference to the housing market and inflation. A bigger focus on housing market problems will most likely lead to more pronounced dollar weakness against the Euro than the Japanese Yen because the market anticipates another interest rate hike from the European Central Bank this year while shorting USD/JPY would require paying a hefty interest. By the same token, if the tone of the statement remains unchanged, expect USD/JPY to benefit more than the Euro. For a more detailed outlook on what the Federal Reserve meeting could mean for the US dollar, see our special FOMC Report.

Japanese Yen Skyrockets on Stronger Economic Data and Not Just Risk Aversion
For the third consecutive trading day, the foreign exchange market has been obsessed with the strength of the Japanese Yen. Rising risk aversion continued to be blamed for the move, but with the Dow up over 90 points today, it is difficult to believe that investors are really all that risk averse. Instead, the rally is more likely driven by the turnaround in the Japanese economy. Having struggled to grow for the past few months, we are finally beginning to see Japan reap the benefits of Yen weakness. Last night, the country reported the first positive reading in annualized retail sales in 8 months. This follows yesterday’s announcement that the Corporate Service Price Index (CSPI) hit a 9 year high in the month of May. The combination of rising consumer spending and growing inflationary pressures is just what the Bank of Japan needs to see before raising interest rates again. Industrial production which is due for release this evening is also expected to swing into positive territory in the month of May. At this point, there is also a decent chance that we will see stronger consumer prices on Thursday. If everything prints positive, then a 25bp rate hike on July 12 or August 23rd becomes a real possibility. With the Dow rebounding and the FOMC announcement tomorrow afternoon, further carry trade unwinding may be limited.

Euro Stuck in a Range; Swiss Franc Weakens After KoF
The Euro continues to be stuck in a tight trading range that is typically more characteristic of a currency pair like EUR/GBP or EUR/CHF. Economic data has been light with French business confidence being the only piece of noteworthy economic data released from the Eurozone today. Unlike German business confidence, which deteriorated in the month of June, French business confidence was stronger than expected. Overall, the Eurozone economy is still performing well enough to warrant another interest rate hike from the European Central Bank. ECB members continue to remain hawkish. Quaden reminded the markets today that the central bank is closely monitoring upside inflation risks. The FOMC meeting could drive some movement in the EUR/USD as well as tomorrow’s German unemployment figures. Stronger employment could pave the way for an upside surprise in German retail sales on Friday. Meanwhile over in Switzerland, KoF leading indicators fell short of expectations in the month of June. This led to broad based weakness in the Swiss Franc.

British Pound Holds Steady as Markets Welcome in New UK Prime Minister
Next to the Japanese Yen, the British pound performed the best against the US dollar today. After a 10 year rule under Tony Blair, UK citizens and global investors are excited to welcome in a brand new Prime Minister. Gordon Brown, the new man on the job has frequently been credited for navigating the economy through its longest period of growth in the past two centuries. His tenure as Chancellor of the Exchequer has earned him respect from around the world. This sentiment has allowed the market to shrug off weaker economic data. The CBI retail sales index tumbled from 31 to 17 in the month of June, well below the market’s 25 forecast. Although cold weather has played a primary role in slowing sales, the drop in spending suggests that we could see deterioration in consumer confidence on Friday.

Commodity Currencies Slip After RBNZ Op-Ed Article
The Australian, New Zealand and Canadian dollars have all sold off significantly despite the rebound in commodity prices. Economic data was weaker than expected overnight, but much of the fall was related to fear of further intervention from the Reserve Bank of New Zealand. The RBNZ issued an opinion article on their website indicating intervention is “an ongoing process.” Although intervention to date has been futile, traders are not willing to take the risk. Meanwhile, New Zealand also reported a weaker than expected trade surplus in the month of May. This should not impact the first quarter current account balance due out tonight because trade data in the first three months of the year was healthy. Australia also reported softer leading indicators for the month of April, which comes in stark contrast to the stronger data that the market has become accustomed to seeing.

Kathy Lien is the Chief Currency Strategist at FXCM.