Is Bernanke the Grinch Who Stole Christmas?
The Federal Reserve cut interest rates by 25bp today, causing US stocks and carry trades to plummet and the dollar to strengthen significantly. For the traders who were hoping for a larger 50bp rate cut and a strong stock market rally, Bernanke may be the Grinch that stole Christmas. Minutes before the interest rate decision, stocks rallied indicating that more traders were adjusting their positions for the possibility of a larger rate cut. Unfortunately, not only did the Fed fail to cut interest rates by 50bp, but they also only lowered the discount rate by the same amount (25bp). The statement reeked of caution as the Fed acknowledged the slowdown in economic growth, the intensification of the housing market correction and the softening of business and consumer spending. They still feel that inflation could rise, but the upside risks to inflation no longer balance the downside risks to growth. This has caused Rosengren to vote in favor of a 50bp rate cut. Last month’s decision was also not unanimous, but at that time, Hoenig voted in favor of leaving interest rates unchanged. The probability of a recession is at the highest level in more than 3 years according to the latest WSJ.com survey. No problems were solved with today’s quarter point rate cut and that is why fed fund futures are pricing in more easing in 2008. The dollar could rally for the remainder of the week, but we expect weakness to resume as we get closer to the end of the year because the Fed won’t be able to avoid looser monetary policy. Pimco’s Bill Gross is calling for 3 percent interest rates, which means that he expects another 125bp of easing. Wholesale inventories fell to the lowest level ever in relation to sales in the month of October. The trade balance and import prices are due for release tomorrow. We expect both numbers to be stronger as the weak dollar boosts import prices and exports.

Euro Hit by Continual Weakness in Investor Morale
Analysts refuse to give up on their bearish outlook for the Eurozone economy. The ZEW survey which measures investor morale dropped to the lowest level in 15 years as “financial experts” fear that rising credit costs will hurt the growth outlook for the region. This comes at odds with the German IFO survey of business sentiment and the comments from the ECB who still see steady growth in the coming year.

Liquidity is definitely a problem as Euro LIBOR rates rose to their highest level in 7 years this morning. If rates continue to rise, the ECB will be forced to keep rates unchanged and they could possibility inject another round of liquidity into the markets. Eurozone industrial production and the French current account are due for release tomorrow. These reports are not expected to be market moving which means that the degree of follow through buying of US dollars will be the primary driver of currencies over the next 24 hours.

British Pound: More Weakness in Store?
The British pound reversed sharply ahead of the FOMC rate decision. At the beginning of European trading, the British pound was doing well and appeared to be on its way to closing higher for the fourth straight trading session. The UK trade deficit narrowed much more than the market expected as exports grew by 1.8 percent and imports eased 1.9 percent. With industrial production firm and the export component of PMI increasing, stronger trader numbers were not a tough call. Yet it is still surprising that given the high level of the British pound in the month of October, exports actually increased. This is partly due to the continued demand from the Eurozone. Over the past year, the pound has actually weakened 7 percent against the Euro. Tomorrow we have UK employment numbers which could trigger more losses in the GBP/USD. Employment is expected to be firm with jobless claims falling, but the drop in the employment components of service, construction and manufacturing PMI signal weakness.

Australia, New Zealand Dollars Plummet on Carry Trade Weakness
The Australian, New Zealand and Canadian dollars suffered greatly from the sharp reversal in the Dow and the sell-off in carry trades. We only had minor data released from Australia and New Zealand last night. Business confidence in Australia dropped as companies become more concerned about the ramification of recent interest rate hikes. New Zealand terms of trade increased in the third quarter while the percentage of house sales improved; these numbers were not market moving. Looking ahead, Australian consumer confidence is due for release along with the Canadian trade balance. The strong Canadian dollar should continue to hurt exports, which could lead to a smaller trade surplus. USD/CAD has been fluctuating in a tight range and the merchandise trade balance is the only piece of Canadian data that has the power to cause the currency pair to breakout. For the Australian and New Zealand dollars, their currencies will be dependent upon the market’s appetite for risk.

Japanese Yen Crosses Dragged Lower by 294 Point Drop in the Dow
Japanese yen crosses sold off significantly as the Dow reversed course following the FOMC rate decision. The losses in US equities were sharp as the Dow closed near its intraday low. This was the biggest move in stocks in close to two weeks and represents a major shift in trend. The yen will continue to rise and fall by the Dow and not Japanese economic data as disappointments fail to catch the market by surprise. Last night, Japan reported the weakest level of consumer confidence in 4 years, but we already got a hint of this from the Eco Watchers survey which also deteriorated significantly. Tonight we are expecting CGPI and the current account. We expect these numbers to be yen positive, but the focus for traders should be the Nikkei and whether it follows the Dow lower.

Kathy Lien is the Chief Currency Strategist at FXCM.