Is the US Dollar the New Funding Currency for Carry Trades?
The Federal Reserve’s interest rate decision is less than 24 hours away and market participants are holding their breath for what will undoubtedly be an active trading session. Yesterday, we outlined 4 different potential outcomes for the Fed meeting , with the most likely being a quarter point rate cut followed by a neutral FOMC statement. We have also authored a special report talking about whether the Fed will give the markets a treat or trick for Halloween; Speculation has ranged from a 25bp rate cut to a 50bp cut to no rate cut at all. As for the Fed’s stance, they have the choice of acknowledging the downside risks to growth or continuing to focus almost exclusively on inflation. Recent economic data does indicate that growth is slowing, but the slowdown has not been severe enough to warrant another aggressive act. Rate cuts take time to filter into the economy and we think that the Federal Reserve will opt for a more steady series of rate cuts instead of brash measures that are sure to stoke further inflationary pressures. In fact, given recent Fed rhetoric, or the lack thereof, it seems that they would actually prefer to leave rates unchanged. However given extremely one-sided market expectations in favor of a rate cut, the Fed knows there would be serious consequences to disappointing the market, including a sharp repricing of the yield curve. The yield curve is currently accounting for as much as 100bp of easing by the summer of 2008. Remember, carry trades are based not just on the current level of interest rates, but also the future direction of rates. The expectation that US rates are expected to decline further is quickly turning the US dollar into the new funding currency for carry trades next to the Japanese yen and Swiss franc. For the first time in four years, deposits in the euro area maturing in two years offer a higher interest rate than those with the same maturity in the U.S. The last time this happened was in 2003. At that time, the EUR/USD jumped from 1.0 to 1.10 in less than 12 months and then to 1.30 the following year. Therefore 1.50 in the Euro is not only possible but probable. Don’t forget that we also have third quarter GDP, Chicago PMI and Construction Spending also due for release before the Fed rate decision. Growth is expected to slow significantly, construction spending is expected to drop, but manufacturing conditions in Chicago could improve thanks to the weakening US dollar. Consumer confidence fell for a third month in a row in October. Unsurprisingly, Americans are growing more worried about falling home values and rising fuel bills. For these reasons alone, the Fed needs to inject the markets with another dose of confidence.

Euro: More Reasons to Hit 1.50
Interest rates are not the only reason why the EUR/USD continues to rise. German economic data continues to surprise to the upside with the number of unemployed people dropping by a more-than-expected 40k in the month of October. This brought the country’s unemployment rate down from 8.8 to 8.7 percent, the lowest since 1993. The Financial Times has extensive coverage today on why German corporations have been able to weather the strain of Euro strength far better than their French and Italian counterparts. According to the articles, more diversification of sales internationally, increased production in local markets and strong domestic demand has the made the country less sensitive to Euro strength. Even the automobile industry which has been extremely hard hit by the strength of the Euro over the past few years (Volkswagen lost EUR1 billion due to currency fluctuations) is shifting production to the US where costs and profits will be less sensitive to currency fluctuations. ECB officials continue to be worried about inflation. Consumer prices are due for release tomorrow; they are expected to remain above the ECB’s 2 percent target for the remainder of the year, keeping the central bank hawkish and the Euro on its way to testing 1.50.

Australian and New Zealand Dollars Pare Gains, but Canadian Dollar Continues to Rise
After rallying for five straight trading days, the Australian and New Zealand dollars have given back their gains on the heels of commodity price weakness. Both gold and oil prices are lower today, allowing New Zealand dollar traders to overlook a rise in money supply and focus more on the drop in building permits. The Canadian dollar, on the other hand, completely shrugged off the $3 drop in oil prices and the larger decline in industrial and raw material prices. The downtrend in USD/CAD is strong and traders really want to push the currency pair below 95 cents. Canada is so flush with cash that they are cutting the federal sales and corporate income tax. Meanwhile GDP is due for release tomorrow; we are expecting an improvement given the jump in retail sales.

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 due for release. Once again, they are 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 growth is slow. Small business confidence remains weak while the unemployment rate ticked higher last month. Until deflation is beat, carry trades will continue to sing to the tune of the Dow.

British Pound Shrugs Off Weaker Data
For the second day in a row, the British pound rallied despite weaker economic data. The CBI industrial trades report declined from 12 to 9 in the month of October. This follows on the heels of cautious comments from the Bank of England. The strength of the pound seems to be driven primarily by carry trade demand. Nationwide house prices and consumer confidence are also expected to weaken tomorrow.

Kathy Lien is the Chief Currency Strategist at FXCM.