The Path to a Stronger Dollar Is Through a Weaker One
New records will either be made or lost this week because not only do we have a very busy economic calendar, but Federal Reserve Chairman Ben Bernanke will also be delivering his semi-annual testimony on the economy and monetary policy. The weakness of the US dollar and continual rise in oil prices will keep the Federal Reserve hawkish as they bank their hopes for a second half recovery on the movements of the US currency. We have already seen the benefits that a weak dollar can instill on the economy. Just last week, the US reported that exports rose to a record high in the month of May and it could not have done so without a weaker dollar. Since the beginning of last year, the trade weighted dollar has fallen 7.7 percent and is now testing lows last seen in the end of 2004. The jump in the Empire state manufacturing survey confirms that the weak dollar continues to benefit the manufacturing sector. After hitting a 1 year high last month, analysts were looking for a sharp retracement, but activity continued to accelerate with the manufacturing index edging up to its highest level since June 2006. Tomorrow, the action begins with producer prices, followed by the Treasury International Capital flow report, Industrial Production and the NAHB housing market index. Net foreign securities purchases and industrial production are expected to remain strong, but the expectations for producer prices are low despite the jump in import prices. With the rally in the EUR/USD becoming exhausted, any upside surprise could drive a much needed recovery in the US dollar. The FX markets are cyclical, so the path to a stronger dollar will be through a weaker one.

British Pound: The Currency to Watch This Week
The British pound is in play this week. Having hit another 26 year high today, the GBP/USD is now less than 150 pips away from the psychologically important 2.05 level. With so much economic data on the calendar, we will either see a top or a move towards 2.10 over the next four trading days. Tomorrow’s report on consumer price growth will be the first piece of key economic data to come out. The combination of a drop in producer prices and a strong currency suggests that consumer price growth will slow as well. However even though the recent strength of the British pound is expected to push inflation lower, UK economic data has a habit of catching everyone by surprise. Traders will be using the CPI number to forecast whether Wednesday’s release of the BoE minutes from the meeting held earlier this month will be pound positive or negative. The minutes have become extremely market moving – if you recall, the turn that we saw in the middle of June was triggered by surprisingly hawkish MPC minutes. A near unanimous decision to raise rates would accelerate further gains, while more than 2 dissenting votes would probably be construed as dovish, which would mark a top in the currency pair.

Carry Trades hit by a Wave of Profit Taking
With no major US data released today and the Japanese markets closed for a holiday, carry trades have succumbed to profit taking. Aside from NZD/JPY, most of the Yen crosses are either flat or slightly lower. The fact that they did not continue to rise after a fairly large earthquake hit North West and Central Japan is a testament to the currency market’s continual appetite for risk. The Dow Jones Industrial Average is now 50 points shy of hitting 14,000. Based upon last week’s monetary policy meeting, the Bank of Japan is in no rush to raise interest rates. As long as this stance is confirmed by the release of their minutes from the meeting held between June 14 and 15, the market will not be worried that an interest rate hike by the Japanese will be what puts an end to the carry trade. Instead, another major headline about the problems in the sub-prime sector exacerbating could be the catalyst for a sharp increase in risk aversion.

Canadian Dollar Hits New 30-Year High, New Zealand Dollar Advances to New 22-Year High
Oil prices continue to be the driver of strength in the Canadian dollar. The currency pair advanced to the highest level in 30 years as oil prices traded back up towards its 11 month highs. This could keep the central bank hawkish, but eventually they will need to back off. The manufacturing sector is beginning to suffer from the strength of the Canadian dollar. For the second month in a row, manufacturing shipments dropped. New motor vehicle sales also fell 0.8 percent in the month of May. Part of the rally in the currency has also been fueled by merger and acquisition flow. Another deal was announced, but the higher the loonie rises, the more expensive Canadian companies will become. Meanwhile the New Zealand dollar also performed extraordinarily well today. The currency hit a new 22 year high after reporting stronger than expected consumer prices in Q2. The combination of last week’s upside surprise in retail sales and today’s higher inflation numbers suggests that we could see another rate hike from the Reserve Bank of New Zealand in the near future.

Euro Hovers Near Its All-Time Highs
Even though the Euro ended the day near its all-time highs, the currency pair’s inability to extend its rise suggests that it could be setting up for a much needed correction. Consumer price growth slowed last month from 0.2 percent to 0.1 percent in the Eurozone. This is the tenth straight month that CPI has remained below the central bank’s 2 percent target. Although this is hardly a market moving number, if we do see stronger producer prices from the US tomorrow and hawkish comments from the Fed later this week, it could help to trigger a nice correction in the EUR/USD. Germany will be releasing the ZEW survey tomorrow. The market is looking for a firmer number, but given recent interest rate hikes, analyst sentiment could easily deteriorate. Switzerland will also be releasing retail sales. In general, growth has been strong and we expect domestic consumption to confirm that as well.

Kathy Lien is the Chief Currency Strategist at FXCM.