2 keys this week for the US Dollar

US Dollar

It was a good day for the US dollar as the greenback gained ground against all of other the major currencies in the US trading session. To see broad dollar strength seems to be rare these days but the combination of lower oil prices, news that the Iranian President wrote a letter reaching out to President Bush and the prospects for higher interest rates in the US later this week gives dollar bulls a reason to be hopeful.

Although there are a lot of key global economic data due for release, politics will probably trump economics as the primary driver of the FX markets this week. The Bush Administration has been mum about the contents of a letter that Iranian President Ahmandinejad has sent to US President Bush, but according to an Iranian government spokesperson, the letter analyzes the current world situation and ways to relieve tension between the two countries.

Oil prices and the dollar has rallied on fresh hopes that there may actually be a solution to the tensions in the Middle East, but given the most recent threat by members of the Iranian Parliament to withdraw from the nuclear Non-Proliferation Treaty, the hopes for resolution may be wishful thinking. With both sides standing strong, there is the risk that any concessions by Iran in the letter could be minimal and it is even possible that the solution they are proposing involves the US backing off more than Iran itself. Any US responses to the letter is sure to have an impact on the currency market and the specifically, the US dollar.

Furthermore, the date for the Treasury’s FX report has been set for Wednesday at 4pm EST, the same day as the Federal Reserve rate decision. The question of whether the Treasury brands China as a currency manipulator is still up in the air, but with two much anticipated events scheduled for the same day, we can expect some big moves. The market unanimously agrees that the Fed will raise rates by a quarter of point on Wednesday, but they remain divided on whether the Fed would tone down the statement to prepare the market for a pause or even an end to their tightening cycle. The fundamental factors pressuring the US dollar are still here to stay and as I said on CNBC today, the only saving grace for the dollar are investors like Warren Buffett, who may still be bearish on the dollar, but are looking for alternative ways to express this view because shorting the dollar outright has become an expensive bet. Two years ago, selling the US dollar would have cost 1 percent in interest, but with this week’s rate hike, it now costs 5 percent.

Euro

After four straight days of gains last week, the Euro started the second week of May on softer footing despite stronger economic data. Retail PMI figures hit two year highs while German factory orders rose 15 percent in the month of March. The figures suggest that domestic demand is holding on strong, confirming the widely expected rate hike in June as demand accelerates in Germany, France and Italy. GDP growth in the first quarter should be solid but will this be enough to encourage the European Central Bank to continue tightening after next month?

We still believe that if the Euro continues to appreciate that it will have an impact on the central bank’s decision. A stronger Euro helps to offset inflation pressures, so even if oil prices resume its rise, the ECB’s concern could grow at a slower pace. In the meantime however, 1.27 seems to be within their comfort zone as ECB council member Garganas downplays the potential impact of the strong Euro on exports. He also talked up the need for further interest rate hikes if economic data continues to improve. The new buzz phrase among central bankers is “data dependent” and we expect to hear more of this word in the weeks ahead.

British Pound

The British pound ended the day virtually unchanged against both the dollar and the Euro. Stronger inflation numbers failed to lend much support to the currency as the market focuses on factors impacting the US dollar. Both input and output producer prices rose more than expected today confirming expectations that the Bank of England could notch higher their inflation forecasts in their Quarterly report due out later this week. Inflation has been running above their 2 percent target throughout the forecast period and with last week’s composite PMI figures suggesting that growth could also be improving, the British pound is expected to benefit as more traders and analysts move further away from calling for a rate cut by the BoE later this year.

Japanese Yen

The Japanese Yen was the best performing currency today as it rallied against all of the major currencies. With Japanese traders back from their Golden Week of holidays, Bank of Japan Governor Fukui injected a fresh dose of bullishness into the Yen by saying that the central bank is “open” to raising interest rates. Although he added that there is no exact timing of when a move will come, the fact that this comes at a time when the Yen is already very strong suggests that fundamental factors have improved enough that even Yen strength, which has a drag on exports, do not have the central bank worried. It is particularly important to keep an eye on the Japanese Yen this week. As for the proxy for Asian strength and weakness, if the US brands China as a currency manipulator, we could see USD/JPY extend its sell off to the 110 handle. In contrast, if China is not named, we could see some strength in USD/JPY.

Kathy Lien is the Chief Currency Strategist at Forex Capital Markets. Kathy is responsible for providing research and analysis for DailyFX, including technical and fundamental research reports, market commentaries and trading strategies. A seasoned FX analyst and trader, prior to joining FXCM, Kathy was an Associate at JPMorgan Chase where she worked in Cross Markets and Foreign Exchange Trading.