Euro Softer; Yen Firm Ahead of FOMC

In Asia the BSI Large Manufacturers survey showed a dip to 3.1 from 10.5 the quarter prior. Still most analysts took the Japanese number in stride considering the strong gains from the previous quarter.

Additionally the future outlook remained positive, indicating that the prospects for a sustained recovery in Japanese economy remained on track. As a result the biggest move of the night occurred in the EUR/JPY cross with the pair losing more than 120 points in Asia and early European trade.

While Japanese economy continues to impress, the Euro-zone region appears once again to be trapped in a quagmire. In France the continuing unrest over PM Villepin labor reforms, threatens to derail his bid for the Presidency while the upcoming election in Italy promises to be extremely volatile, with some observers fearful that PM Berlusconi may not go gently if he loses.

Thus the sense of tension and foreboding in the EZ seems almost palpable and stands in stark contrast to the renewed sense of optimism in Japan. Little wonder then that the EUR/JPY cross started to weaken. Should the political uncertainty in Europe persist the decline may accelerate.

Meanwhile in the US all eyes will be in on the Fed. The 4.75% rate hike seems pre-ordained but the key will be the Fed communiqué especially with regard to the committee's view of inflation.

To that end we believe the Fed may surprise on the hawkish side despite the sharp drop in US New Home Sales figures on Friday. Evidence is building that second round effects of inflation are staring to seep into prices. Anyone who doubts that fact need only to purchase a cup of coffee from a Manhattan pushcart lately.

As the effects of persistently higher oil prices coupled with a relatively robust labor market add upward pricing pressures on consumer goods, the Fed may go further than the market believes in their rate hike campaign.

With Chairman Bernanke still trying to shake off the effects of his infamous "printing press" speech of 2002 he may wish to prove his bona fides as an inflation hawk and continues stressing the need to curb pricing pressures.

Thus in the end it appears that once again the Fed could go too far and may well tip US into a recession later in the year, but for the time being the dollar bulls could have a chance for one last party.