What is Up Next for the US Dollar Post-FOMC?
The Federal Reserve’s interest rate decision has come and gone and even though the impact on the financial markets has been substantial, the consolidation today indicates that traders are asking, What’s Next? With the EUR/USD hovering below 1.40, everyone is wondering whether it will break that level and if so, what could trigger it. The rest of the economic data due for release this week are not very market-moving since we only have the Philly Fed survey and leading indicators left on the calendar. However, don’t rule out a break and test of 1.40 this week. We have testimonies by Fed Chairman Ben Bernanke and US Treasury Secretary Paulson tomorrow on the state of the mortgage market. The Fed’s decision yesterday received widespread applause from both Democrats and Republicans. It would not be a stretch to say that the upcoming testimony was a factor in Bernanke’s decision to make a more aggressive cut of the Fed funds and discount rate. Had he opted for a more conservative quarter-point cut, we are sure that he would receive tough criticism instead of compliments by Congress tomorrow. Today’s weaker than expected consumer price and housing market reports have had little impact on the currency market. Softer gasoline prices in the month of August have eased inflationary pressures around the world. Oil prices did not climb to record highs until September which means that today’s CPI number may not be an accurate reflection of current inflationary pressures. As for housing, we all know that the housing market is doing poorly. These numbers simply validate the Fed’s decision to ease monetary policy more aggressively. Although the rate cut goes a long way to relieving the risks of a recession, it does not rule out one. We still need to see how non-farm payrolls and retail sales fare in the months forward to determine whether US growth could still slow materially. The futures curve is currently pricing in 50bp of easing before the end of the year. With only two more rate decisions on the calendar, we expect 25bp rate cuts in October and December. Another half-point cut may not be entirely out of the question if economic data remains weak since the Fed has cut rates by half-point clips on multiple occasions in 2001.

Stocks Continue Higher but Carry Trades Fail to Follow
The Dow rallied another 80 points today but Japanese Yen crosses failed to track US equities higher. This price action indicates that traders are cautious and do not want to get overly optimistic. Over the past few months, they have been burned by the problems in the subprime sector. Traders and investors have learned about the consequences of aggressive risk appetite the hard way. Before carry trades even have a chance to return to the multi-decade highs that was characteristic of the first of the half the year, there needs to be proof that the US economy has stabilized and the worst is behind us. At bare minimum, the number of foreclosures and defaults on home loans need to fall and not rise. It is no secret that the outlook for the US economy is a far bigger driver of Yen movements than Japanese economic data. For example, the Bank of Japan left interest rates unchanged last night and even though the Japanese Yen actually rallied in the hours following the monetary policy decision.

British Pound weakens as Bank of England is Forced into Action
Growing evidence that the Bank of England may eventually need to ease monetary policy has pushed the British pound lower against both the Euro and the US dollar. In fact the pound has been driven to the weakest level against the Euro since May 2006. Although Northern Rock tipped the otherwise steady boat, we learned this morning that the Bank of England was already cautious about the economic and inflation outlook at the beginning of this month. Northern Rock will only make them even more concerned. Consumer prices last month dropped only modestly, but the BoE who may or may not have had this information on September 5th felt that the upside balance of risk to inflation has receded. Coupled with the $4.4 billion liquidation injection yesterday and the announcement that UK banks will be allowed to borrow from the BoE using mortgages as collateral, raises the risk of a surprise interest rate cut. The BoE has always been a very dynamic central bank that pays close attention to the changes in economic data. Therefore should the financial markets in the UK fail to stabilize or there is a run on another bank, they will not be hesitant to lower interest rates.

Euro Struggling to Make a New High
The Euro is trading at a very important contention point against the US dollar. It is struggling to make a new all-time high which suggests that there are a lot of option barriers at 1.40. This means there are just as many traders preventing a break as there are ones hoping for one. Given the continued deterioration in US fundamentals and the stability of Eurozone economic data, we still believe that a break of 1.40 is inevitable. US Federal Reserve Chairman Ben Bernanke and ECB President are scheduled to speak tomorrow. Unexpected comments by either of these central bank heads could trigger a sharp rally higher. German producer prices were the only piece of meaningful economic data on the Eurozone calendar this morning and that was right in line with expectations. There is no Eurozone data due for release, but there are quite a number of Swiss data. We are expecting the Swiss trade balance, producer prices, and the ZEW survey. All of these numbers are expected to be softer despite the hawkishness of the Swiss National Bank last week.

Canadian, Australian and New Zealand Dollars All See Strong Gains
The Australian, New Zealand and Canadian dollars performed extremely well today. The Canadian dollar hit a new 30-year high before giving back some of those intraday gains. Oil and gold prices continue to press higher with the liquid commodity hitting another record high as US supplies drop more than expected. At this point, $100 oil may not even be needed to take USD/CAD down to parity.

Kathy Lien is the Chief Currency Strategist at FXCM.