Bank of Canada: Will They Cut Interest Rates?
The Bank of Canada is the first central bank to announce their monetary policy decision this week and traders should be prepared for surprises. The market is currently pricing in a 60 percent chance of a quarter point rate cut even though economists do not expect a move. Recent economic data from Canada has been weak and inflation is falling. For the first time since June 2006, consumer prices slipped below their 2 percent target. This will allow the central bank to err on the side of looser monetary policy if they feel that the trend of economic growth warrants it. Also, oil prices continued to fall, which is keeping USDCAD near parity. If the BoC does cut interest rates, we expect an immediate test of 1.0125, which is a very important resistance level. Even if they do not, we expect the central bank to warn about the possibility of a rate cut in the coming months. The Australian dollar is also weaker due to a sharp fall in gold prices and a record breaking trade deficit in the month of October. With the Australian dollar soaring to 23-year highs last month, import growth significantly outpaced export growth. We will have to see if that also translates into stronger retail sales this evening. The New Zealand dollar was the only commodity currency to hold steady against the greenback. There was no economic data released, but the New Zealand dollar is sitting above very important technical support levels.

US Dollar Slips as Mideast Nations Debate their Dollar Pegs
The US dollar is weaker across the board as the members of the Gulf Cooperation Council debate their Dollar Pegs. The two largest economies in the region, the UAE and Saudi Arabia are divided on whether they should abandon the dollar in favor of a basket peg or to continue to ride out the move and risk taking a further hit to the value of their reserve holdings. The UAE is in favor of a currency basket similar to the one that Kuwait has (more details), while Saudi Arabia dismissed this possibility. A revaluation will be negative for the US dollar, but if things stay status quo and Saudi Arabia wins out, then we could see the dollar bounce. Uncertainty about the outcome of the meeting is keeping the dollar under pressure. Also, Federal Reserve officials continue to grow increasingly dovish. Rosengren who is typically a more modest central banker warned that foreclosures is likely to get worse and the US economy will grow “well below” potential in coming quarters. With such gloomy outlooks, the Federal Reserve will have to continue lowering interest rates. The futures market is still pricing in a 40 percent chance of 50bp rate cut. Meanwhile the ISM manufacturing survey was right in line with forecasts today, which was a bit of a disappointment because the rise in the regional indexes signaled a stronger increase. What’s more, a new multi-month low in the employment reading at 47.8 may suggest a dour long-term outlook on demand and production as employers try to trim costs through layoffs and reduced capital spending.

Euro: Lifted by Stronger Manufacturing Data
As much as analysts and economists may blame the strength of the Euro for holding growth back, we have yet to see any real evidence of this happening. The manufacturing PMI numbers for the month of November were strong, with activity in France and Germany continuing to accelerate. The unemployment rate also dipped from 7.3 percent down to 7.2 percent. Producer prices are due for release tomorrow and we expect inflation to remain a big problem. The European Central Bank is widely expected to leave interest rates unchanged on Thursday and based upon recent economic data ECB President Trichet will continue to warn that higher interest rates may be to come if inflation does not subside. Economic conditions in Switzerland are also promising with the SVME Purchasing Managers Index increasing from 60.7 to 63.4 last month. The Swiss economy is tight which should pave the way for another rate hike from the SNB next year.

British Pound: Stronger Economic Data Drives Short Term Recovery
The British pound has rebounded today thanks to broad dollar weakness and stronger manufacturing data. November PMI increased from 52.9 to 54.4, well above the market’s 52.6 forecast. Next to the Bank of Canada, the Bank of England’s monetary policy decision is probably the most interesting one this week because the chance for a rate cut is fifty-fifty. Like Canada, the UK has been suffering from weaker economic data, but unlike the US’ northern neighbor, inflation remains a problem. The Financial Times has an article openly wondering about whether the UK would face a mild version of stagflation, which is slowing growth in an inflationary environment. Problems continue to plague the UK financial sector with RBS being the latest bank to reveal subprime losses. They are expected to announce GBP2 billion in write offs which is another reason why the BoE could surprise with an interest rate cut on Thursday. In the meantime, construction sector PMI is due for release tomorrow and we do expect pound bullish numbers.

Japanese Yen Stronger Across the Board as Stocks Give Back Gains
The Japanese yen is the strongest currency of the day, having rebounded against all of the major currencies. The US stock market reversed course in afternoon trading which has helped the yen extend its rise. Stronger capital spending and labor cash earnings also helped, but both indexes remain in negative territory. They are headed in the right direction however because wage growth needs to edge back into positive territory before the Bank of Japan can consider raising interest rates. Central Bank Governor Fukui’s comments today were fairly neutral. He indicated that he was aware of the risks of keeping rates too low and pledged to raise them gradually but at the same time he was uncertain about how much damage the subprime crisis would have on the global economy.

Kathy Lien is the Chief Currency Strategist at FXCM.