Tomorrow’s Federal Reserve interest rate announcement will be a defining point for the currency market. After leaving interest rates unchanged since June 2006, the Fed is expected to make their first policy adjustment in over a year. Fed fund futures are currently pricing in a 54 percent chance of a 50bp cut against a 46 percent chance of a 25bp cut. Leaving rates unchanged is not a conceivable option. How the markets will respond to tomorrow’s decision will be dependent upon not only what the Fed does, but also what they say. If the Fed cuts rates by 25bp and remains hawkish, we expect the stock market to drop, the US dollar to rise and carry trades to suffer because a quarter point cut would be seen as a disappointment to a market that is looking for the Fed to be ahead of the curve, not behind it. With oil prices hitting a new record high at a time when LIBOR rates are falling off their highs and the stock market stabilizing, Bernanke may not be willing to drop his inflation fighting bias. The mildest reaction in the markets, on the other hand, may be off of a 25bp cut that is accompanied with warning of more easing to come. This indicates that Bernanke is not committing to anything but is acknowledging the fact that the economy is in trouble. In this case, we expect the dollar to weaken slightly. A half point cut by the Fed, however, will most likely result in a sharp drop in the US dollar and a nice pop in the stock market, which may be bullish for carry trades because a larger interest rate cut would be seen as an uncharacteristically proactive move by Bernanke. Of all these scenarios, we think that the Fed will only put a band aid to the growing problem by reducing 25bp even though the market really needs a half point cut. Meanwhile, the only piece of economic data released today was the Empire State Manufacturing survey which was much weaker than expected. The employment component was the highest since December 2006 but this tends to have a weak correlation with non-farm payrolls. Aside from the FOMC rate decision, we are also expecting producer prices, Treasury international capital flows and the NAHB housing market index. This of course will be overshadowed by the market’s expectations for the Fed rate decision.

British Pound Continues to Weaken Despite Guarantee of Deposits
Northern Rock’s financial troubles continue to plague the British pound. Despite the UK Chancellor’s announcement that the government will guarantee all deposits of Northern Rock account holders, the British pound has fallen for the fourth consecutive trading day to break below 2.0. The risk of troubles at other UK banks is keeping buyers away, and the UK government’s pledge will do little to keep depositors from withdrawing money first and asking questions later. At this point, the Bank of England has no choice but to lean towards easier monetary policy. Up until now, they have been criticized for not taking any major steps to calm the financial markets. With Northern Rock, they have finally been forced to make the biggest UK bank bailout in 30 years. Going forward, the market will expect the Bank of England to leave interest rates unchanged for the remainder of the year with the risk of easier monetary policy if there are further problems in the UK banking sector. Tomorrow, we have UK consumer prices due for release. After dropping 0.6 percent on a monthly basis in July, the rise in oil and drop in the sterling is expected to drive consumer prices higher.

Canadian Dollar Hits New 30-Year High
The Canadian dollar hit a new 30-year high today on the back of stronger economic data and record oil prices. Foreign purchases of Canadian securities were expected to drop 4.5 billion in the month of July, but instead, they rose for the first time in 3 months by 1.5 billion. Demand for Canadian equities was very strong, which may suggest that foreign investors expect the Canadian economy to remain resilient in the face of slower US growth. If oil prices extend their rise that may be the case as the profits of Canadian resource companies continue to grow. The Australian and New Zealand dollars on the other hand are weaker despite a much stronger than expected service sector PMI report in New Zealand. This is due to the fact that the US dollar has strengthened on the speculation that the Fed will disappoint.

Euro: Waiting for Direction
The Euro is hovering not far from its record highs as it waits for direction from the US Federal Reserve. The German ZEW survey is due out tomorrow and we expect a sharp drop in business confidence as the problems in the credit markets drive borrowing costs higher. As a major exporter, Germany is especially vulnerable to a global slowdown. Although this will probably weigh on the Euro, the impact should be limited as the real action in the currency pair may not come until 2:15pm EST, when the Federal Reserve makes their monetary policy decision. If the Fed reduces rates by only 25bp, we may see a near-term top in the EUR/USD. We are also expecting Swiss industrial production. The SNB was surprisingly hawkish last week and the market expects the numbers to confirm their rosy economic outlook.

Bank of Japan Not Expected to Change Interest Rates
Carry trades have come under pressure ahead of the FOMC rate decision. This has nothing to do with Japanese data since none was released overnight. The Bank of Japan will be announcing its interest rate decision this evening, but we do not expect a reaction in the currency market since financial market turmoil and political uncertainty will prevent the BoJ from lifting interest rates. Instead, we expect carry trades to continue to move in lockstep with the Dow tomorrow in reaction to the Fed’s interest rate decision.

Kathy Lien is the Chief Currency Strategist at FXCM.