Will the ECB Cut Interest Rates by June?
There is nothing that the US Federal Reserve can do or say at the present time to surprise currency traders. They have cut interest rates by 125bp since the beginning the year and they are expected to bring rates down by another 50 to 75bp over the next few months. The market has predicted and properly priced in every one of their moves and for that reason, last week’s exceptionally weak US economic data failed to drive the dollar even lower. Instead, it was European Central Bank President Trichet’s acknowledgment that growth will continue to slow that did the trick. The EUR/USD dropped over 200 pips as the market realized that the next move by the ECB will probably be a rate cut and not a rate hike. Even though ECB members tried to temper the Euro’s slide by saying that the central bank did not consider a rate cut or that they have not relaxed their view on inflation, everyone is now focused on timing the ECB’s rate cut. The financial papers are packed with articles forecasting slower Eurozone growth. JPMorgan Chase is now calling for 2 quarter point rate cuts by June; before the ECB announcement on Thursday, they were forecasting a rate hike in the first quarter of 2009. Lehman Brothers believes that there will be one 25bp rate cut in June. As the ECB admits, inflation is a big problem, so we believe that if they were to cut interest rates, they would do it very slowly, so we lean closer to Lehman’s view than JPMorgan’s. With interest rates being the primary driver of currency fluctuations, even though the US is easing at a more aggressive pace than the ECB, it is old news. The ECB’s shift in sentiment on the other hand is something new and currency traders are rushing to adjust their positions in reflection of that. The German ZEW survey is due for release tomorrow. Weakening economic data and the ECB’s refusal to lower interest rates should drive analyst sentiment lower, keeping pressure on the Euro.

Dollar Gives Back Gains on Cautionary Comments from G7
After last week’s risk aversion driven rebound in the US dollar, the greenback has given back some of her gains after cautionary comments from G7 finance ministers. No direct comments on currencies were made but their official statement said that downside risks persist and without being specific, they pledged “appropriate actions, individually and collectively.” In other words, things have gotten so bad that another coordinated action like the one that we had in August may be needed. As a result, the central bank of the US and other G7 members such as the UK, Canada and the Eurozone will be taking steps to reduce market turmoil and boost growth. This will include things like further rate cuts and lower taxes. There is no major US economic data until Wednesday which leaves Eurozone data as the primary driver of
currency fluctuations tomorrow. A continued deterioration in the German ZEW survey could help the US dollar hold onto its strength. On Wednesday however, US retail sales will dominate the global economic calendar and all of the risks that the dollar faces should return to the forefront. Last week, we talked extensively about how the weak dollar is hitting both Main Street and Wall Street. Whether the US economy is in a recession is just a matter of semantics at this point. Non-farm payrolls, service sector ISM and consumer spending are all flashing recessionary signals. Therefore the Fed’s job is not to try to classify the current level of growth but to find ways to prevent a more significant downturn.

Stronger Inflationary Pressures Drives British Pound Higher
The UK economic calendar is chock full of important economic data this week. January producer prices were released this morning and much stronger than expected numbers helped the British pound recover some of last week’s extensive losses. The numbers suggest that the Bank of England could slow down their pace of rate cuts as prices at the factory gate surged to 16 year highs. Consumer prices are due for release tomorrow and the forecast is for a 0.6 percent drop. Given the rise in producer prices and the low forecast, there is a decent chance that we will also see consumer prices grow more than expected. The rest of the data released this morning mattered little as the wider trade deficit was offset by a rebound in house prices. The UK economy is slowing and the question ahead is whether high inflation will prevent the BoE from easing interest rates as aggressively as necessitated by the UK economy.

Australian and New Zealand Dollars Extend Gains, Canadian Dollar Left Out of the Mix
The Australian and New Zealand dollars were the best performing currency pairs today as hawkish comments from the Reserve Bank of Australia cemented the currency’s status as the only leading high yielder to still be raising interest rates. According to a statement released by the RBA last night, monetary policy could be tightened further if economic growth does not slow materially. The New Zealand dollar is up marginally as it rides on the coattails of Australia’s good news. The Canadian dollar on the other hand sold off following weaker than expected growth in house prices.

Carry Trades Fail to Rally Despite Rebound in US Stocks
US stocks closed higher today by 57 points, but Carry Trades refused to rally. Other than AUD/JPY which was led higher by the Australian dollar, all of the Yen crosses ended the day lower. We continue to stress that the relationship between carry trades and the Dow is breaking as risk aversion and high volatility limits the attractiveness of carry trades. An article in the UK Telegraph also argues that Japanese banks are not disclosing a lot of subprime losses. We suspect that many traders are just staying out of the Yen crosses.

Kathy Lien is the Chief Currency Strategist at FXCM.