Federal Reserve: 4 Scenarios for Wednesday
The foreign exchange market is relatively quiet today with the US dollar continuing to weaken and commodity currencies continuing to strengthen. No US economic data was released and the only piece of market-moving data expected tomorrow is consumer confidence. Therefore it was little surprise to see Wednesday’s FOMC meeting as the market’s main focus. Although we think that the Fed meeting is very important because it has the potential to shift market expectations and set the tone for trading for weeks to come, traders should not lose sight of the fact that third quarter GDP and non-farm payrolls could also trigger sharp market volatility this week. For the upcoming Fed rate decision, there are four scenarios that we need to consider. The first and most likely scenario is a 25bp interest rate cut. With this scenario, the reaction in the US dollar would be dependent upon the tone of the FOMC statement. Should the Fed leave the FOMC statement unchanged or keep the tone neutral, the dollar should rally going into Friday’s non-farm payrolls report. We actually think this possibility is quite likely since Federal Reserve officials including Bernanke have been reluctant to signal that a rate cut is needed. The second scenario is the Fed leaving rates unchanged and the third is a 50bp rate cut. The former would be bullish for the US dollar but bearish for stocks. The latter, on the other hand, would be very dollar bearish and stock market bullish. The fourth scenario is one brought up by Federal Reserve President Mishkin late last week. He suggests that the Fed could cut the discount rate by 25bp rather than the Fed funds rate, which would also be bullish for the US dollar and bearish for the stock market since it indicates that the Fed’s concern about inflation far outweighs its concern about corporate profitability, housing and growth. Bernanke and company have a tough decision to make on Wednesday with oil prices closing at a new record high above $93 a barrel. The threat of stronger inflationary pressures is significant and one that the Fed will not be able to ignore.

Bank of Japan to Leave Interest Rates Unchanged Again
The Japanese yen will be in play tonight with the Bank of Japan interest rate decision following on the heels of labor market and unemployment data. Once again, the Bank of Japan is not expected to raise or cut interest rates because they have no room to do so. Even though retail sales were stronger than expected and rose unexpectedly for the second month in a row, the trend of consumption is slow because weak wage growth remains one of the country’s biggest problems. The unemployment rate is expected to remain at a 9-year low, but troubles in the US and tight credit conditions globally will force the Bank of Japan to stand aside for the remainder of the year. Deflation still remains a bigger problem than inflation in Japan. Carry trades are stronger as the US stock market extends Friday’s gains. In the immediate future, further strength in US and Asian stocks would undoubtedly take the Japanese yen crosses higher as well.

Canadian Dollar Hits 37-Year High
No trend in the currency market is as strong as the recent downtrend in USD/CAD. Today, the Canadian dollar raced to a 37-year high against the US dollar on the back of a new record in oil prices. We have long said that 95 cents is not only possible but probable in USD/CAD and now that this level has been achieved, the next logical target is 90 cents. Further gains however could be difficult as $100 oil will be a difficult psychological barrier to surpass. Even though we remain bullish the commodity currencies, the moves in the Canadian dollar and oil have become very extreme and are begging for a reversal. Meanwhile the Australian and New Zealand dollars are also stronger today thanks to $5 rise in gold prices and better than expected New Zealand trade deficit data. If commodity prices continue to rally, so will the commodity currencies.

Euro Hits New Record High
The Euro hit a new record high of 1.4439 today on the back of broad dollar weakness and stronger regional consumer prices in parts of Germany. Despite the disappointing German IFO report last week, European Central Bank officials have remained mum about the current level of the Euro. To many, this lack of concern has been interpreted as an endorsement for further Euro strength. At this point a test of 1.45 in the Euro seems inevitable. If the currency manages to break above that on the back of bearish US news, 1.50 could be viable. Don’t expect this to come as soon as tomorrow however since all we have are Eurozone retail PMI and German unemployment. The labor market is expected to improve but consumer spending is expected to weaken.

British Pound Breaks Higher Despite Weak Data
The British pound outperformed both the US dollar and Euro today despite mixed economic data. Even though net mortgage lending increased to 9.8 billion from 8.5 billion last month, the drop in mortgage approvals to a 26-year low indicates that this increase is not a reflection of a stronger housing market but instead a reflection of higher credit costs. It is becoming more expensive to service these loans, which is why the amount of credit outstanding has increased even though mortgage approvals and house prices have both decreased. Inflationary pressures according to M4, the UK’s broadest measure of money supply, remained unchanged. The Bank of England’s dour outlook leads us to believe that UK interest rates will be left untouched until the beginning of the new year.

Kathy Lien is the Chief Currency Strategist at FXCM.