Interest Rates: Where are they Headed?
There are six central banks announcing interest rate decisions this week and two out of the six have already made their decisions official, with the Reserve Bank of Australia raising rates by 25bp and the Bank of Canada lowering rates by 50bp. In the currency market, it is not about what you have done but what you plan on doing in the future that matters, which is why both the Australian and Canadian dollars sold off after the monetary policy meeting. Interest rates in Australia are now at a 12-year high, but that did not prevent the Aussie from falling over 1 percent against the US dollar, Euro and Japanese yen. After raising interest rates by 100bp over the past 8 months, the RBA is pressing on the breaks while the BoC is pushing on the gas pedal. According to the statement given by Governor Stevens, domestic demand is moderating and tight financial conditions could cause growth to slow even further. In other words, it is very likely that last night’s rate hike from the RBA was their last. As for the Bank of Canada, not only did they cut interest rates by more than the market expected, but new Governor Mark Carney warned that “further monetary stimulus is likely to be required in the near term.” Despite record oil prices, Canada is growing increasingly worried that the slowdown in the US economy will have significant spillover effects, which is why they are trying to be as proactive as possible by cutting interest rates now rather than later. This has triggered a sell-off in the Canadian dollar that should last for at least the next few days. Tomorrow, the Reserve Bank of New Zealand will be making their own interest rate announcement. Unlike the RBA or the BoC, the RBNZ is not expected to alter interest rates but they are expected to remain hawkish. In addition to the RBNZ meeting, Australia will also be releasing fourth quarter GDP. A drop in retail sales and trade in the last 3 months of 2007 should hang heavily over growth, keeping near term pressure on the Australian dollar.

US Dollar: Time to Shift Focus to Non-Farm Payrolls
The US dollar extended its weakness against the Euro, British pound and Japanese yen as traders begin to shift their focus to Friday’s non-farm payrolls report. Tomorrow we are expecting a number of leading indicators for non-farm payrolls including the Challenger Layoff report, the ADP employment survey and service sector ISM, which should be a big market mover. If service sector ISM fails to recover, there is a decent chance that we will see a particularly horrid non-farm payrolls number on Friday. Fed officials are also dueling it out on inflation which suggests that the Beige Book report, which will also be released tomorrow could focus primary on growth. Federal Reserve Governor Mishkin believes that the US economy faces grave risks and inflation pressures would abate because of that, justifying Bernanke’s particularly bearish stance last week. Fed President Fisher on the hand told a conference in London that “containing inflation” should be the purpose of the Federal Reserve and “if a temporary economic slowdown is what we must endure while we achieve that purpose,” then it is a burden that they “must bear, however politically inconvenient.” This leads us to wonder whether the rate cuts by the Federal Reserve is pressured more by politics than economics, but that’s debate for another day. We continue to believe that the US dollar will see further weakness before it stands a chance at recovering in the second half of the year.

Euro Holds Near Record Highs
The Euro is holding up well near its all-time record highs as comments from ECB officials suggest that intervention risk is minimal. Although Eurogroup Junker believes that the euro is overvalued, he feels that this is more a problem with the US dollar than the euro itself. Most European officials recognize the fact that a strong currency is needed to contain inflation. With corn prices at a record high and rice prices at 20-year highs, it may just be a matter of time before we see a big jump in consumer prices. At this point, the ECB needs their currency to be strong and growth to slow in order to have any chance of bringing inflation back below their target. Eurozone PPI and GDP were right in line with expectations so there was no major reaction in the Euro. Service sector PMI and retail sales are due for release tomorrow; we expect the numbers to continue to be euro positive. Meanwhile the Swiss franc is stronger across the board following the hottest pace of GDP growth in 2 years.

British Pound: Ready for a Big Breakout
The British pound has been consolidating for the past week and the contracting range signals that the currency is prime for a big breakout. Our technical analyst believes that the breakout will be to the upside which aligns well with today’s sharp reversal in US stocks. Having been down over 200 points intraday, we may now see another 200-point rally in stocks. Over the medium term however, UK rates are still headed lower and we believe that fundamentally, weakness should still be the dominant trend in the British pound. UK economic data has been mixed with construction sector PMI falling short of expectations and manufacturing sector PMI beating them. Service sector PMI is due for release tomorrow which could be the catalyst for a break in the pound.

Yen Crosses Struggling to Recover
With the US stock market falling 450 points since last Thursday and as much as 650 points intraday, carry trades continued to struggle. CHF/JPY is the only yen cross that closed in positive territory while AUD/JPY is the day’s biggest percentage loser. Finance Minister Nukaga believes that the economy is still on the path to recovery and recent data appears to suggest this possibility.

Kathy Lien is the Chief Currency Strategist at FXCM.