US Dollar

Yesterday, we said that it was very likely the market was too optimistic on the potential contents of Iran’s letter. If anything, “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. “ Today, the US revealed that the letter from the Iranian President was far from diplomatic. According to reports, Iran criticized the US for its policies and offered little solutions. More letters are expected to other heads of state, which only means that tensions with Iran will continue to remain on the lips and fingertips of all traders.

The US dollar has sold off as it erases all of yesterday’s gains against the majors as oil prices resume their climb. Gold prices also hit $700 for the first time in 25 years. If today’s two major events prove to be dollar negative as well, we expect to see fresh year to date highs in the Euro, Japanese Yen, Swiss Franc, Australian and Canadian dollars. In order for both events to be dollar negative, we would need to see the US Treasury brand China as a currency manipulator and more neutral comments from the US Federal Reserve, suggesting that the Fed will really be closing the door on further rate hikes. If both of these unfold, we could easily see a 200 point move in the EUR/USD. In contrast, if the Fed leaves most of the FOMC statement unchanged and the US Treasury does not brand China as a currency manipulator, we expect to see a relief rally in the US dollar.

But what about the middle ground? Everyone seems to be talking about either the black or white scenario, but it is just as likely for the US Treasury to tighten up their stance on China without labeling them outright. The last report published in November 2005 applauded China for the changes that they made to their currency regime last July. At the time, they said that because of the move, they refrained from designating China as a currency manipulator. So who is to say that rather than doing a complete about face, the US Treasury would not choose to revert back to the comments they made in May 2005. They could just as easily acknowledge China’s steps towards moving to a more flexible system, but criticize them for not doing enough and repeat that if they do not substantially alter their policies soon, they would meet the Treasury’s technical requirements for being designated as a currency manipulator. The US Treasury’s report comes at a sensitive time politically where the US has an interest in drumming Chinese support for a strategy in dealing with Iran.

Remember, the report is just as much political as it is economic. Therefore, harshening their stance on China’s policies without out rightly branding them yet may be a good middle ground for the US at this point. As for the Federal Reserve, tomorrow could also be a critical turning point in the monetary policy. According to a study that we conducted in 2005, any “pauses” after a prolonged tightening and easing cycle tend to lead to sharp moves in the US dollar. We have already seen the greenback sell off on speculation that the Fed may be done, therefore if they officially move to neutral, losses in the dollar could be exacerbated. However, since the market is extremely bearish dollars at the moment, anything to the contrary will probably lead to a sharp dollar recovery.

Euro

The Euro is stronger today climbing just shy of its yearly highs as the outlook for the US dollar worsens. Even though there are some very important pieces of Eurozone economic data due for release tomorrow including German trade reports and French industrial production, the US dollar will undoubtedly drive market price action. Today is a perfect example of this dynamic as traders completely shrugged off a surprisingly weak German industrial production report. In the month of March, manufacturing activity saw its biggest decline in seven years. Falling 2.4 percent on a monthly basis, construction activity was the primary source of weakness as output among builders dropped by 15 percent. Cold weather and high oil prices are weighing on the Eurozone’s largest economy which should temper some of the hawkishness that we have recently been hearing from Eurozone central bankers.

British Pound

Led higher by dollar weakness, the British pound is trading less than 40 points away from its 12 month highs against the US dollar. The Bank of England is scheduled to release their much anticipated Quarterly Inflation report tomorrow morning. As we have been mentioning, the market expects the central bank to raise their inflation forecasts. The producer price figures released yesterday confirm that inflation pressures are rising. Furthermore, consumer prices have remained above their 2 percent target throughout the forecast period. If the BoE delivers what the market expects, we will probably see a modest rise in the British pound since much of it has already been priced in. On the flip side, if they fail to do so, expect a sharp sell-off in the British pound. Dollar factors will dominate trading today so any weakness would probably be best expressed in EUR/GBP.

Meanwhile, there is news that UK Prime Minister Tony Blair may step down next year. According to the UK Telegraph, Blair said that he may not go to the end of his term. He added that if he did step down, he would give his successor who he has anointed as Gordon Brown ample time to establish himself before the next elections. One of the Members of Parliament present at Blair’s speech predicted that he would hand over the job to Brown at the party’s conference in the autumn of 2007. The changing of the guard in the UK will probably be taken as a positive development since the market holds high regards for Brown and it also puts an end to Blair’s low approval ratings.

Japanese Yen

Once again the Japanese Yen has seen broad based strength. If the US Treasury brands China as a currency manipulator, the Japanese Yen will probably suffer the most. Aside from speculation on what the Treasury will do, the yen is also rallying on reports that the Bank of Japan may raise their economic outlook in their monthly report on the economy due out next week. With the Bank of Japan moving closer to raising interest rates, the pressure on the US dollar and the pressure on China has only exacerbated the yen’s strength. Even if by some off chance that there are little moves tomorrow, the long term outlook for the Yen is still tipped more favor of strength than weakness.

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.