It’s Judgment Time for the US Dollar as Market Prices in 44% Chance for 75bp Cut
The number one driver of the US dollar at the moment is interest rates, which is why we continue to focus on how many basis points the Federal Reserve will be shaving off the Fed funds rate at the end of the month. Throughout the past week, interest traders have been increasing their bets for a larger move which has led to widespread dollar weakness. Believe it or not Fed fund futures are now pricing in a close to fifty-fifty probability of a 75bp rate cut. Yesterday they were pricing in only a 50bp rate cut but today, Fed fund traders have gone crazy. As bearish as Federal Reserve Chairman Ben Bernanke may have been yesterday, there is zero chance that they will cut interest rates by 75bp at the end of this month. Although there has been one 75bp rate hike in the past 15 years, the last time that interest rates were reduced by more than 50bp at a single meeting was in 1984, after Paul Volcker had taken interest rates to a high of 20 percent to tame double digit inflation. By raising interest rates as aggressively as he did, Volcker managed to bring inflation down from its peak of 13.5 percent in 1981 to 3.2 percent by 1983. Are we coming off double digit interest rates or even high single digit interest rates for that matter? No. Is it confirmed that we are in a recession? No. If anything, the recent weakness of the US dollar contributes to inflation and the continual rally in gold prices indicates that higher inflation pressure is the bigger problem in the market at the moment. Therefore how could the Fed realistically lower rates by 75bp? A 50bp rate cut would already be overly generous. For the US dollar, Tuesday is judgment day. We are expecting retail sales and producer prices which will give us a glimpse into how desperately the US economy needs a larger rate cut. Although Bank of America’s purchase of Countrywide Financial should have been very positive for US stocks, Merrill Lynch’s $15 billion potential write down reminded traders that the worst of the subprime crisis is not behind us. If retail sales are weak and consumer price growth slow, it will be enough to convince the Federal Reserve to cut by half a point. In addition to those numbers, we are also expecting TIC, industrial production, Beige Book, housing starts and the Philly Fed survey, which means that it will definitely be a very volatile week in the currency market.

Euro Struggles to Stay Above 1.48
Will three times be the charm for the EUR/USD which has struggled to stay above 1.48 for the third time this month? Weak Eurozone economic data and an overall drop in risk appetite has forced the single currency to give back some of yesterday’s spectacular gains. Despite the correction, we still expect the EUR/USD to hit 1.50, especially since today’s price action does not reflect the sharp shift in interest rate expectations. German wholesale prices and industrial production was soft and Eurozone economic data will probably continue to weaken, but Euro strength or weakness depends largely on who is doing worse, the Eurozone or the US. ECB President Trichet remains committed to raising interest rates or least keeping them steady, which will remain positive for the Euro. Next week the only market moving releases that we are expecting from the Eurozone are the German ZEW survey of analyst sentiment and Eurozone consumer prices. These pieces of data will be taking a back seat to the heavily market moving US economic calendar. Meanwhile the Swiss franc ends the week on a strong note. The ZEW survey is the only piece of economic data expected from Switzerland next week.

British Pound: Don’t Expect 2008 to be a Good Year
The British pound was the worst performing currency this week, having fallen to a record low against the Euro, a 3-year low against the Swiss franc and a 1.5 year low against the Japanese yen. Even though the British pound has only fallen to a 9-month low against the US dollar, the fact that it has weakened against a currency whose outlook is just as dismal indicates how bearish investors are on the UK economy. Having missed an opportunity to be ahead of the curve by cutting interest rates on Thursday, the Bank of England will have a tough battle ahead of them because 2008 will not be a good year for the British pound. Next week, producer and consumer prices are due for release along with labor market numbers and retail sales which means that it will be another volatile week for the beleaguered currency.

Canada on a Very Different Path from Australia and New Zealand
The Canadian economy is on a very different path from Australia and New Zealand. Over the past week, Australian economic data continued to surprise to the upside, confirming the strength of the Australian economy. Canada, on the other hand, has reported nothing but disappointments. Last month, the country lost 18k jobs, the most since 2003. This year, we expect the Bank of Canada to cut interest rates by at least another 50bp. Australia and New Zealand on the other hand will probably leave rates unchanged. Next week the focus will turn to Australia and New Zealand with Australian employment numbers, New Zealand consumer prices and retail sales due for release.

Dow Erases Weekly Gains Triggering Sharp Carry Trade Liquidation
The 246 point drop in the Dow today erased all of this week’s gains in both US equities and carry trades. With no major news other than Merrill Lynch’s write down, a wave of risk aversion has swept through the financial markets. Despite a relatively busy Japanese economic calendar next week that includes machine orders, CGPI and the current account, the fate of the Yen crosses will largely depend on the outlook for the Dow. As long as the problems related to the subprime crisis are not behind us, it will be difficult for carry trades to return to their glory days.

Kathy Lien is the Chief Currency Strategist at FXCM.