Federal Reserve Sends 3 Messages to the Markets: Countdown to Easing Begins
It has been a busy week in the financial markets with two to three hundred point intraday swings in Carry Trades and the Dow quickly becoming the norm. Both the US stock market and carry trades took a beating this week. The US dollar on the other completely reversed its downtrend and came close to erasing all of its year to date losses against some of the majors. Central banks have pumped over $350 billion in liquidity into the markets with limited success, forcing the Federal Reserve to lower the discount rate from 6.25 to 5.75 percent this morning in addition to injecting more liquidity into the financial system. Along with the cut, they issued a statement that was far more dovish than the one released at the August 7 FOMC meeting. This sent three messages to the market. The first is that the liquidity injections have not been enough. The second is that the subprime, credit and liquidity debacle is indeed hitting the “real economy” and the third is that they have officially dropped their hawkish bias which means their next move will be to cut interest rates. Cutting the discount rate is different from cutting the Fed Funds target rate (see our Special Report for more details), but by doing so, the chance for a September rate cut has multiplied significantly. The interest curve is now pricing in 75 basis points of easing by the end of the year. In response to the discount rate cut, the dollar has given back its gains, carry trades have rebounded and the Dow ended the day in positive territory. The next monetary policy meeting is not until September 18th which will be the market’s main focus over the next few weeks. There are 3 possible scenarios. The first is for the Fed to cut the Fed Funds target rate by 25bp in Sept and Oct. The second is to cut by 50bp in Sept and the third is to delay an interest rate cut until Oct. The first scenario is the most likely one, but the second and third will be the bigger market movers. Unsurprisingly, the University of Michigan survey of consumer sentiment dropped to the lowest level in a year. We expect consumer confidence and consumer spending to continue to be weak as mortgage payments begin to rise, companies begin to slow hiring and homeowners are pushed into foreclosure. In the week ahead, handicapping what the Federal Reserve will do in September will continue to be the predominant driver of market fluctuations. The economic calendar is relatively light with only leading indicators, durable goods and new home sales due for release.

Will the ECB Still Cancel its Plans to Raise Rates in September?
The Federal Reserve’s reduction in the discount rate today raises the question of whether the European Central Bank will follow through with raising interest rates next month. The probability of an ECB rate cut has dropped from 90 percent two weeks ago to 25 percent today. Many banks have shifted their outlook and are now not calling for a September rate increase. Today, ECB member Weber said that the central bank will do all that they can to ensure price stability and when asked whether the central bank still plans on raising interest rates or use strong vigilance on price risks, he declined to comment. This definitely suggests that the central bank could cancel its plans to raise rates next month. Economic data is showing signs of slowing alongside inflation. This morning’s German producer price data reflected a 0.1 percent monthly drop in July. ECB President Trichet has not shown any signs that he too is reconsidering the central bank’s earlier plans to cut rates. We will be watching his commentary closely in the next few weeks. Meanwhile, even though the German ZEW report is due for release next week along with GDP and Eurozone PMI, the data should take a backseat to the movements in the equity and bond markets. Switzerland also has a lot of data due for release including producer prices, trade balance and employment. Not many people have talked about whether the Swiss National Bank will still raise rates. At this point, we think that the chances are low.

Reserve Bank of Australia Intervenes for the First Time in 6 Years
The Reserve Bank of Australia is desperately trying to prop up its currency. From its July 25 high, the Australian dollar has fallen as much 13 percent against the US dollar and 20 percent against the Japanese Yen. The currency’s losses over the past week are steepest in 24 years and far surpass the biggest weekly loss in October 1998. Even though the Australian dollar reversed quite a bit today, the initial reaction off of the RBA intervention was minimal. In fact, the Australian dollar went on to hit a new 9 month low in early European trading. With only $64.87 billion in foreign exchange reserves, the central bank has little to work with. However, their intervention indicates that they have shut the door on further interest rate hikes. The New Zealand dollar moved in lockstep with the Australian dollar while the Canadian dollar reversed significantly after the Fed’s discount rate cut. There is a lot of data on the Canadian calendar next week, so expect the currency to be in play. There is no Australian data but New Zealand will be releasing their trade balance.

Volatility Rocks the British Pound
The British pound has been extremely volatile this week due to active trading in the GBP/JPY which has moved up and down a hundred pips within a blink of an eye. It has been an exceptionally tough week for the British pound, which has lost approximately 400 pips against the dollar and more than 1000 pips against the Japanese Yen. Hopefully that will change with the heavy UK calendar next week. The Bank of England is one of the few central banks sitting on their hands throughout the credit market and liquidity debacle.

Japanese Yen Crosses Reverse Course After Fed Announcement
The Japanese Yen Crosses recovered most of their earlier losses after the Federal Reserve lowered the discount rate. At one point, all of the crosses were in the green for the day when the Dow opened up over 300 points. The Nikkei took a heavy beating last night with the index down 5.4 percent, which was the largest drop in 7 years. The announcement by the Fed today should help to stabilize some of the Asian markets. At this point, there is zero chance that the Bank of Japan will be raising interest rates next week.

Kathy Lien is the Chief Currency Strategist at FXCM.