During his semi-annual conversation with Congress, Ben Bernanke, Chairman of America’s Federal Reserve Bank suggested the US economy may soon begin to slow, due in part to the Fed’s monetary tightening. Thus, hinted Bernanke, the Fed will likely pause after hiking interest rates in May, and take some time to evaluate the state of the economy as well as the full effect of its monetary policy. This sent a ripple through futures and forex markets, which had previously expected the Fed to raise interest rates at least twice more before stopping. The Financial Times reports:

“Bernanke’s comments suggest that the market has got a little ahead of itself…, and as the market scales back such thoughts the dollar will likely come under further pressure.”

Read More: Bernanke comments weaken dollar

The G7 Industrialized nations recently called on China to afford the Yuan increased flexibility. Many pundits likened the comments to similar exhortations made several years ago (regarding increased Euro flexibility). After that announcement, the USD declined over 10% against most major currencies within one year’s time. Will a similar fate befall the USD this time around? It seems likely, as the G7’s comments may ultimately pave the way for equally serious words of encouragement by America’s Treasury Department, in its semiannual currency report. AME Info reports:

For the very first time ever, China has been mentioned directly by the G7, reflecting their increased concern over the past few months.

Read More: Dollar Slides as Pressure Increases on China to Revalue- Will it Matter?

Last year, the strength of the USD against the Euro came as a great surprise to currency traders and economists, alike, who believed it was only a matter f time before fundamental factors caught up with the dollar. In the last few months, however, the Euro has steadily climbed against the USD, all without much fanfare. This week, it crossed a psychological barrier and reached the milestone of 7-month high. The currency has been buoyed by strong economic indicators, notably German business confidence data. Marketwatch reports:

“The euro strengthened across the board as strong data and official comments contributed to expectations the ECB could ramp up its tightening path.”

Read More: Dollar low vs. euro, steadies on yen

As the EU economies gather momentum, the belief that the European Central Bank will tighten monetary policy to head off inflation is gaining widespread acceptance. And with it, talk of forex reserve diversification is spreading. Several OPEC countries have already announced they will begin to invest oil profits in Euro-denominated securities. Further, in a display of European solidarity, Sweden will adjust the composition of its reserves so that European assets represent a majority. Finally, Russia will soon begin rotating a portion of its $61 Billion oil fund into European bonds. AME Info reports:

With the breakdown of the EU Constitution well behind us, the market has feels that reserve diversification is a theme that is here to stay.

Read More: More Central Banks Talk of Diversifying to Euro

Last week, the World Trade Organization (WTO) became the most recent addition to the chorus of voices calling for revaluation of the Yuan. The most prominent advocates of Yuan revaluation, which include the United States, European Union, Japan, and the International Monetary Fund had previously invoked the correction of global imbalances as the prime justification for reform. The WTO, in contrast, is encouraging revaluation on the grounds that it will enable China to conduct an independent monetary policy and control inflation. The Financial Express reports:

The yuan on Wednesday rose the most against the dollar since a revaluation in July, following speculation that pressure from US President George W Bush and strengthening Asian currencies will force China to allow faster gains.

Read More: WTO urges China to make its currency more flexible

One of the most fundamental principles of macroeconomics dictates a nation’s currency should depreciate when its current account balance is negative, in order to induce foreigners to buy its products and services. What happens when foreigners substitute their purchase of goods and services for stocks and bonds? This is precisely the question that economists and currency traders have been asking themselves for years, as the US current account deficit has ballooned while foreigners continued to purchase American assets. According to the most recent data, foreigners are on pace to buy nearly $1 trillion of American debt and equity this year. This number has remained fairly constant and suggests the USD will remain buoyant until demand for US assets declines.

Read More: Foreigners Flock to U.S. Securities

This week, China announced it would officially do away with caps on capital outflows. Previously, a business or retail investor wishing to exchange Yuan for foreign currency had to petition the government to do so. Moreover, the amount of currency that could be exchanged was capped at a low value. With this latest move, China has signaled that it is ready to move towards a floating currency system, in which individuals would be free to buy and sell as much Chinese currency as they wished. In the short run, this should help to reduce some of the upward pressure on the Yuan. Xinhua News reports:

The government…made it easier for individuals and firms to buy foreign currency and invest abroad, including allowing domestic banks to invest in financial products outside the mainland.

Read More: Nation to abandon forex quotas for investments

This week, an article in the Wall Street Journal insinuated that the Fed would likely raise interest rates only one more time, if at all. The article, which incorporated both economic indicators and economists’ sound-bites, caused a minor stir in forex markets, as traders tweaked their models to account for the change in expectations. The latest consensus, which is also reflected in interest rate futures, is that the Fed will raise interest rates in May, for the final time in its current cycle of monetary tightening. Furthermore, such futures also indicate a low likelihood of an encore rate hike in June. Marketwatch reports:

Meanwhile, persisting concern about the clash between Iran and the West and the possibility of U.S. military intervention in Iran also weighed heavily on the greenback.

Read More: Dollar slumps on rate outlook, Iran

This week, Hu JinTao, Prime Minister of China, will visit the United States for the first time since he assumed power. As you probably guessed, the Yuan will be a hot topic of conversation between Chinese and American officials. It bears mentioning that American politicians continue to call for a 25% increase in the value of the Yuan, as economists feel the Yuan is undervalued. However, forex markets reflect slightly different expectations with regard to the path of the Yuan. Specifically, Yuan currency futures indicate investors believe the Yuan will only appreciate 2.8% this year. Non-deliverable Yuan forward contracts, which serve a similar purpose, have priced in a 3.1% gain. While there remain a few analysts that believe the Yuan will rack up double digit gains against the USD this year, the majority of traders expect the Yuan to continue appreciating gradually. Reuters reports:

JP Morgan…expects the dollar to fall to 7.00 yuan by the end of this year, but admits that the market is pricing in less than a 2 percent chance of this occurring.

Read More: Currency markets bet on small yuan appreciation

For months, Euro bulls have used fundamental economic analysis to support their claim that the Euro was due to appreciate against the USD. They have since been joined by many technical analysts, who jumped on the Euro bandwagon after the Euro seemingly broke out of a tight range that it had been confined to for months. Forex markets have also begun to take note, using even insignificant economic indicators as a basis for Euro support. The USD, in contrast, has shown scant signs of life, despite improved prognoses for American monetary policy and a stabilizing trade imbalance. Dow Jones News reports:

The widely expected dollar demise slated for in the latter part of the year may be upon us, as the euro rallies to more than a two-month high versus the greenback and flirts with levels close to the year high.

Read More: Euro Strength Vs Dollar May Be Here To Stay

As far as currency traders are concerned, trade data is the most important in the spectrum of economic indicators. Economic theory suggests a nation’s currency should appreciate when its balance of trade is positive, and vice versa. Accordingly, when the monthly report on US trade data revealed a decline in the US current account deficit, dollar bulls rejoiced. In fact, the deficit narrowed by 4.1%, its largest drop in several months. However, pessimists are predicting that next month’s data will reveal a sharp expansion in the deficit, in order to compensate for this month. AFX News Limited reports:

For the long term, many analysts think structural considerations will become more of a concern to currency markets especially as the US Federal Reserve is expected to call a halt to its rate hike cycle by the summer.

Read More: Dollar wins brief respite from better than expected US trade data

According to a senior member of the European Central Bank (ECB), the bank may raise interest rates at its next meeting, which is currently scheduled for June. As you may recall, there was a frenzy of speculation that surrounded the Bank’s last meeting, as many analysts had expected a rate hike. According to the official, however, the ECB merely wants to wait and confirm that actual growth and inflation figures accord with expectations. In short, it seems the ECB is in the process of tightening its monetary policy, but the pace may be a little slower than usual. Bloomberg News reports:

With the Federal Reserve also tightening credit and the Bank of Japan likely to do so before the end of 2006, the world economy faces the first round of synchronized rate increases in six years.

Read More: ECB’s Liebscher Signals June Rate Increase as Economy Picks Up

It’s official: the US is no longer alone it its exhortation of China to further revalue the Yuan. In a press conference held earlier this week, the Finance Minister of Austria (the nation that currently holds the rotating presidency of the EU) suggested that the Yuan must be allowed to appreciate. He argued that such a step was not only in the long-term of interest of China, but would also help correct global economic imbalances. His calls for revaluation closely mimicked those of the US, with one notable difference. The Finance Minister insisted that the Yuan revaluation should be accomplished gradually, whereas American politicians would like to see it take place in one swift motion. AFX Limited reports:

The EU Commission reportedly backs a more gradual approach because of concerns that sudden yuan adjustment could weaken the dollar against the euro.

Read More: EU presidency’s Grasser, ADB’s Kuroda seek gradual move to flexible Yuan

This year, the US current account deficit is projected to reach $800 Billion, an astounding 7% of GDP. If current trends continue, the deficit will jump to 13% of GDP by the end of the decade. Moreover, this year will probably mark the first ever that the net US return on foreign investment will be less than the money earned by foreigners on US investments. For this trend to be reversed will require a massive depreciation in the value of the USD. Unfortunately the US is tightening monetary policy at a faster rate than the rest of the developed world, which renders such a reversal unlikely. The Economist reports:

Not only is the yen relatively weak in nominal terms, but falling prices in Japan have made it even more competitive.

Read More: The Yen also Rises

In the days and weeks leading up today’s meeting of the European Central Bank (ECB), the Euro had begun to gather steam as traders and analysts braced for the bank to signal a rate hike in May. Such a move would be a step towards reducing the differential between European and American interest rates. Jean-Claude Trichet, president of the ECB, had a different agenda, however, delicately warning investors not to expect such a rate hike. Analysts quickly reconfigured their models, hoping that the rate hike will merely be postponed by a month, rather than cancelled. The Financial Times reports:

Market expectations still point to rates of 3.25 per cent by the end of the year, but whereas this was a 100 per cent certainty before Mr. Trichet’s comments, the probability fell to 80 per cent afterwards.

Read More: Euro slips as Trichet douses May hike hopes

While the last few months have witnessed rising talk of forex reserve diversification, China seems intent on preserving the status quo. Representatives from China’s Central Bank recently announced that the nation’s foreign exchange reserves, which are already the largest in the world, would likely grow by at least $100 Billion in 2006. This is due both to the soaring current account surplus and the vast sums of foreign capital that continue to be invested in China. Further, the bulk of these new reserves will likely be held in USD-denominated assets, which are valued for their liquidity. Forbes reports:

Xinhua quoted Cao as saying that it would be unwise for China to sell off its dollar assets because they are still the most reliable assets in the world.

Read More: China forex reserves to rise by at least 100 bln usd in 2006

Over the past decade, many aspects of India’s economy have been loosened and reformed as the country sought to match the growth of China. One facet that has yet to be liberalized, however, is the exchange rate system. While the Indian Rupee is technically free-floating, repeated intervention by India’s Central Bank has prevented it from appreciating. Further, the Rupee remains only partially convertible, for it is very difficult for Indians to invest domestic capital in foreign assets. As a result, India has built up foreign exchange reserves of nearly $150 Billion. This may soon change, as India’s parliament is finally mulling the possibility of full convertibility. The Economist reports:

A more open capital account would bring great benefits—notably, faster growth through easier access to capital. A convertible rupee is also essential if Mumbai is to fulfill Mr. Singh’s ambitions for it as a regional financial center.

Read More: Fear of Freedom

Headlining a recent spate of economic data was the monthly report on EU manufacturing data, which indicated Euro-area manufacturing is growing at the fastest rate in nearly five years. Echoed by other economic indicators, the data suggests that the European economic recovery is slowly feeding into labor markets. On Thursday of this week, the European Central Bank is scheduled to meet to discuss the future of EU economic policy. The consensus is that the bank will leave rates unchanged at this meeting, but will signal the likelihood of a rate hike in May. The Financial Times reports:

The strength of the indices suggested the stronger growth expected to be shown in gross domestic product figures for the first quarter of 2006 would continue into the second quarter.

Read More: EU manufacturing recovery gathers pace

The sum total of all of the world’s foreign exchange reserves now exceeds $4 Trillion, according to the most recent economic data. 2/3 of these reserves are held in USD-denominated assets, which places the owners of these reserves in an especially precarious situation. Leaders of the G7 will soon meet to discuss this problem, with the goal of ensuring the stability of the global economy and capital markets. However, any ‘solution’ would invariably involve a diversification into a broader array of assets, via a shift out of the USD, which has Dollar bulls sweating. Reuters reports:

Another proposal is simply to prevent global market disruption by making composition of the reserves more transparent and encouraging more detailed and regular reporting of reserve totals and their breakdown.

Read More: Reserve hoarding begs for multilateral solution

In all likelihood, the next couple of years will witness a narrowing of interest rate differentials between the US and Europe. Accordingly, many analysts are predicting risk-averse investors to begin migrating their capital from the US to Europe, which would cause the Euro to appreciate. Leaders of Central Banks have begun to make their own preparations in response to this expected trend. The United Arab Emirates has already announced its intention to increase the portion of its forex reserves held in Euro-denominated assets from 2% to 10%. Other Arab nations, including Iran and Syria, are mulling similar propositions. If these nations ultimately decide to diversify, it could feed back into forex market psychology and hasten the dollar’s decline. Dow Jones News reports:

U.A.E. officials have repeatedly said that if they move out of dollars, it will be because of market dynamics rather than because of politics. Such a move would reduce the risk that the central bank would incur heavy losses should the dollar weaken sharply.

Read More: Threat Of Middle East Reserve Move Stresses The Dollar