Could the Federal Reserve Cut by Another 100bp in 2008?
Last year, the Federal Reserve cut interest rates by 100bp to prevent a major slowdown in the US economy. Although their efforts have forestalled a recession, it has not prevented one from potentially happening in 2008. Non-farm payrolls in the month of December were abysmally weak, leading many bank analysts to revise their calls for how much the Fed will ease on January 30th. One week ago, the futures market was only pricing in a 30 percent chance that rates will be at 3.5 percent by the end of April (which is 75bp below current levels). However, after the release of December non-farm payrolls, the market started to price in as much as 100bp of easing over the next 4 months. 100bp in 2007 and 100bp in 2008 would bring rates down to 3.25 percent, the lowest since June 2005. We believe that the chance for interest rates in the US to be 3.25 percent or lower by the end of 2008 is high, but whether half of that easing will happen in January remains to be seen. The growth of 18k jobs in the month of December was the weakest that we have seen since August, 2003 when the US economy shed 42k jobs. Unfortunately there was no silver lining in the report. A look into the details reveals that if the government did not increase public sector hiring, job growth would actually be negative last month. On top of that, the unemployment rate increased to a 2-year high while the annualized pace of earnings growth slowed from 3.8 to 3.7 percent. These levels indicate that we are either already in a recession or headed for one. Within seconds of the data release, the US dollar fell 100 pips against the Japanese yen as the futures market began to price in a greater chance for a 50 vs. 25bp rate cut at the end of this month. Although the Fed could cut rates by 50bp, we doubt that today’s non-farm payrolls number has cemented their decision. There are still 18 trading days until their monetary policy meeting. If oil prices break $100 a barrel and consumer prices or retail sales surprise significantly to the upside, the Fed could opt to drag out their easing cycle into the summer and lower rates at 25bp clips instead of acting more aggressively by cutting rates 50bp in January. In the week ahead, there are a lot of speeches by Fed officials but no meaningful US data until Friday. The US dollar should continue to weaken, but we would not be surprised to hear see new measures from the Bush Administration to stimulate growth.

Euro: Headed for 1.50? Revisited
In yesterday’s Daily Fundamentals, we said that we do not expect the Euro to hit 1.50 unless we see negative drop growth. Even though the US economy added 18k jobs last month, if you strip out the government’s 31k contribution, job growth was negative. Looking purely at economic fundamentals, we can see why the EUR/USD is headed for further gains. Today, the US unemployment rate rose to a 2-year high which comes in stark contrast to the German unemployment rate which fell to a 6-year low last month. Economic conditions in the Eurozone as a whole remain steady, and their outlook for growth is more promising than the US which should allow the European Central Bank to remain hawkish next week when they announce their monetary policy decision. If anything, recent rhetoric from ECB officials and the trend of energy prices could force the central bank’s threats to get louder. Meanwhile with consumer prices hitting a 12-year high, we could also see a rate hike from Switzerland in the first quarter.

What Kind of Impact Will the BoE Rate Decision Have on the British Pound?
Even though the British pound ended the US trading session unchanged against the US dollar, it is still one of the weakest currencies in the FX market because it gave back nearly all of its intraday gains. Economic data was mixed with service sector PMI increasing but consumer credit and mortgage approvals decreasing. The Bank of England will be announcing their interest rate decision next week. They are not expected to lower interest rates, but that does not mean that their interest rate cut on December 6 will be their last. The BoE could ease by as much as 75bp this year if economic growth continues to deteriorate. Since the threat to inflation is not as strong in the UK compared to the Eurozone and the US, the central bank has the luxury of focusing on the problems in the housing and credit markets. Aside from the BoE rate decision, we are also expecting the UK trade balance, leading indicators and industrial production next week.

Australian New Zealand and Canadian Dollars Hit by Softer Commodity Prices and Carry Trade Liquidation
Despite very weak US economic data, the greenback actually strengthened against the Australian, New Zealand and Canadian dollars. Softer oil and gold prices can be partially blamed for the underperformance, but the primary reason why the commodity currencies are lower is because they have been hit by another wave of carry trade liquidation. Australian service sector PMI actually increased last month, so if anything, economic data should favor AUD/USD strength. The Canadian dollar, on the other hand, is suffering from the weakest Canadian IVEY PMI since Decembe,r 2001. We only expect Canadian economic data to get worse. The employment component dropped significantly last month, which suggests that we could see a similar deterioration in the CAD employment numbers next Friday.

Dow Ends Worst Week of Trading in Over 100 Years
The Dow dropped another 256 points today, making it the worst first week of trading in over 100 years. Traders across the markets have become extremely risk averse as weak US economic data suggests that the outlook for the US economy could get materially worse before it gets better. Given that the Dow ended the day at session lows and Asian traders have not had an opportunity to react to the NFP number, carry trades could be headed for more losses in the beginning of the new trading week.

Kathy Lien is the Chief Currency Strategist at FXCM.