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As we countdown to the Federal Reserve's monetary policy meeting, conflicting inflation, Treasury international capital flow (TIC) and manufacturing numbers will make the Fed's decision on Wednesday particularly difficult. Granted the U.S. central bank is not expected to alter interest rates or the size of their Quantitative Easing program, their degree of hawkishness or dovishness could set the tone in the dollar for the reminder of the year. Producer prices which measures wholesale level inflation increased 1.8 percent in November with core prices rising 0.5 percent. On an annualized basis, PPI rose by the strongest pace since October 2008. Unsurprisingly, the weakness of the U.S. dollar, rise in gasoline and other energy prices played a big role in pushing PPI higher but aside from a drop in the price of passenger cars and computers, stronger price pressures was seen everywhere. However unlike oil prices, gas prices fell gradually last month which means that even though we also expect consumer prices to rise, the pace of growth may not be as strong as PPI.

Conflicting Manufacturing Activity

Stronger inflationary pressures, a pickup in consumer spending and a dramatic improvement in the labor market should encourage the Fed to adopt a more hawkish tone on Wednesday. Unfortunately the sharp drop in the Empire State Manufacturing survey will make it difficult for the Fed to be anything more than cautiously optimistic. The index fell from 23.51 to a five month low of 2.55 which indicates that manufacturing activity slowed significantly last month. The only saving grace is the rise in industrial production in November and the increase in capacity utilization which suggests that the slowdown in the NY region may be unique to the Empire State.

Foreign Demand for Dollars Decline

The dollar did weaken slightly following the Treasury International Capital flow report which indicated that foreign investors were net sellers of dollar denominated assets in the month of October. Even though demand for long term U.S. Treasuries increased, demand for short term liabilities declined, creating a net outflow of $13.9B. Brazil, HK, Ireland and France were the biggest buyers of U.S. dollars while the U.K., Luxembourg and Japan were the biggest sellers. Chinese demand was flat in October. The trend of investors are shifting from short to long term investments represents their greater confidence in the U.S. recovery.

Significance of Turn in Dollar Positioning

The EUR/USD has fallen significantly over the past 12 hours on the speculation that Austrian Banks may be the next to crumble. We think it is worthwhile to revisit a point that we made in our daily report last evening which suggested that the turn in dollar positioning last week foreshadowed a deeper decline in the euro and stronger rally in the U.S. dollar.

On Friday, the CFTC released their weekly Commitment of Traders Report, which measures positioning in the commodity markets. According to data from the Chicago Mercantile Exchange, future traders have reduced their short dollar positions across the board. In fact, speculative positioning in the EUR/USD turned net short for the first time since May. This shift from net short to net long dollars against euros is extremely significant. Since 2005, there has only been approximately 4 times (not including this time) that EUR/USD positioning has flipped to net short after being net long by more than 20k contracts. Each time, this shift in dollar positioning was a precursor to a more significant rally in the U.S. dollar. According to the following chart, the last time that speculative EUR/USD positioning (white line) flipped from net long to net short was in the first week of August 2008 and interestingly enough, that was the very week that the breakdown in the EUR/USD began, with the currency falling more than 3,000 pips or 20 percent over the next 3 months. W are certainly not saying that the EUR/USD& nbsp; will fall 20 percent from current levels because the move in the EUR/USD following each shift in dollar positioning has varied in terms of magnitude. However, the yellow vertical lines on the chart show that a flip consistently foreshadows a sell-off in the EUR/USD. If the Fed grows more hawkish on Wednesday, we could have a fundamental trigger for a more meaningful decline in the EUR/USD.

About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.