Bernanke Talks, Dollar Tanks, 90% Chance for 50bp Rate Cut
The US dollar got killed as today’s comments from Federal Reserve President Ben Bernanke sent expectations for a 50bp rate cut at the end of the month skyrocketing. We have kept you up to date with the day to day changes of rate cut expectations because they have shifted so dramatically over the past week. Two days ago, there was only a 66 percent chance that the Fed would cut by a more aggressive by 50bp, but today, Fed fund futures are pricing in a 90 percent chance that the US central bank will opt for the bigger move. Market expectations are extremely important when it comes to the Fed’s interest rate decision because, judging from recent actions by Team Bernanke, they frequently bow to market pressures. More specifically, they deliver exactly what is priced in, nothing more, nothing less. This means that if 100 percent of traders are looking for a 50bp rate cut, the Federal Reserve will be worried about the consequences of under-delivering in a fragile market environment. The outlook for growth is certainly not encouraging. In his speech on the economy, Bernanke barely touched on inflation and instead focused almost exclusively on growth. He said that the 2008 outlook has worsened, housing has weakened further, while the deterioration in the jobs data raises the risk of softer consumer spending. As a result, Bernanke warned that they stand ready to “act in a decisive and timely manner.” Not only is further easing necessary, but we could realistically see interest rates 100 to 125bp lower this year. There was nothing positive in Bernanke’s comments, which make a 50bp rate cut very likely. Wholesale inventories and sales were stronger than expected but they had no impact on the US dollar. Tomorrow the US trade balance and import prices will be released. Weak manufacturing PMI numbers suggest that exports could be soft, which would widen the deficit.

ECB Leaves Rates Unchanged, But Hawkish Comments Trigger More Euro Gains
The European Central Bank left interest rates unchanged at 4.00 percent this morning. No one expected the ECB to move so the actual decision was a non-event for the Euro. It was not until ECB President Trichet opened his month that the Euro really take off. Even though the central bank head did not make any groundbreaking comments, his commitment to preventing second round effects was more than satisfactory for Euro bulls. Only two options were discussed at the meeting; leaving rates unchanged or raising them. For the ECB, inflation remains a very big problem and because of that, they are ready to act preemptively on rates because waiting for second round effects to manifest themselves would be too late. On growth, Trichet acknowledged that the risks are to the downside, but for the time being, he still feels that euro-area fundamentals remain sound and growth should remain around potential. Even though it is unclear whether Trichet is all talk and no action, the ECB’s threat to raise rates comes in stark contrast to the Federal Reserve’s hints of more aggressive easing – and this is all that matters for the time being.

Is the Bank of England Behind the Curve?
Last year, the Bank of England’s reputation went up in flames when they were late to react to the credit crunch. Today, they had an opportunity to redeem themselves, but once again, they are behind the curve. The pace of deterioration in UK economic data has increased significantly over the past few weeks, leading many traders to wonder whether the British pound will repeat the dollar’s 2007 weakness. It is not a matter of if, but a matter of when, we will see another rate cut from the Bank of England. Traders are now expecting a move in early February, but what difference does it really make to postpone the move by 4 weeks? Oil prices are below $95 a barrel which means that in the immediate future, inflation should not get out of hand. The BoE really missed an opportunity to prevent a more significant slowdown in the housing market and consumer spending. It would be a shock if the minutes for this meeting, due on January 23rd were not dovish. Going into the monetary policy meeting, the market was pricing in a 60 percent chance of a BoE rate cut. We expected a rally in the GBP/USD if the Bank of England left rates unchanged and we did see a 70 pip knee jerk reaction. However, the currency pair reversed just as quickly as it has risen, indicating that no one believes the BoE’s December rate cut will be their last. UK industrial production is due for release tomorrow. The deterioration in manufacturing PMI suggests weaker numbers.

Commodity Currencies Rally, But Will the Move Last?
For once, the Australian, New Zealand and Canadian dollars are all moving in the same direction. Unfortunately there is not much to explain this cohesive price action because commodity prices are mixed, with oil prices down $1.82 and gold prices up $13.17. Economic data was also mixed. Strong export orders helped to improve the Australian trade balance, which provided further gas for Aussie and Kiwi bulls. Canada, on the other hand, reported higher house prices but a steep drop in building permits. Canadian unemployment and merchandise trade are due for release tomorrow. We expect both figures to be negative for the Canadian dollar.

Reluctant Rally in Carry Traders
The Dow climbed another 117 points today which should have been overwhelmingly positive for carry trades. Unfortunately only four out of the seven yen crosses that we follow actually rallied. GBP/JPY, USD/JPY and CAD/JPY all sold off because of the disappointing fundamental outlook for these three countries. The UK, US, and Canada all lowered interest rates in the month of December and recent economic data suggests that more interest rate cuts are needed.

Kathy Lien is the Chief Currency Strategist at FXCM.