Federal Reserve: Arguments For and Against a September Rate Cut
With London markets closed for their Summer Bank holiday, trading in both the equity and currency market has been extraordinarily quiet. The dollar was mixed as the degree of disappointment in the July existing home sales report failed to be as large as many people may have expected. The amount of homes sold was slightly higher than analyst expectations, but still the weakest level in close to 5 years. Furthermore, the supply of unsold homes hit the highest level since 1991 while the median home price dropped 0.6 percent from a year ago. Home sales could have been and could still be a lot worse. The conflicting housing market reports will do little to help the Federal Reserve determine what to do with interest rates next month. Expectations for a September rate cut have pared as volatility decreases. Although a rate cut will certainly be the Fed’s next move, there are a growing number of people calling for the move to come in October instead of September. They believe that the liquidity injections and the discount rate cut has done enough to help stabilize the credit markets for the time being. The Federal Funds effective rate has been below the Fed Fund’s 5.25 percent target rate since the beginning of August. Over the weekend, Federal Reserve Presidents Poole, Lacker and Fisher all attempted to calm the markets by talking up the resilience of the US economy and the possibility of a stable labor market. Fed watchers John Berry and Greg Ip have written extensive commentary on why a September rate cut is a possibility but not a certainty. This past weekend, Ip listed six other ways that the Fed could boost the markets before resorting to cutting interest rates. Meanwhile, the arguments in favor of a rate cut in Sept are just as compelling. Risk aversion still remains high in the financial markets as investors of all sizes stay in cash or as close to cash as possibility. A rate cut is needed to not only lower the cost of borrowing, but the lower yield will also give investors a reason to accept more risk for higher return. On a consumer level, adjustable rate mortgage repricing will not peak until October, which means that the real economy could feel more pain in the coming months. Lenders are already increasing interest rates on everything from mortgages to credit card balances. Corporate profitability has and will continue to be pinched. Non-farm payroll reports for August, September and October are not expected to be pretty. If the Fed does not want to see another 1000 point drop in the Dow, they may have no choice but to cut interest rates in September. The bottom line is the Fed needs to make up their mind about whether it is more important to be proactive or reactive.

ECB Trichet Non Committal About September Rate Hike
Like the Federal Reserve, the European Central Bank has not made their decision about what to do with interest rates next month. This morning, the market was hoping for more clarity from Trichet on whether they are sticking to their August 2nd monetary policy bias in favor of raising rates. However instead of providing more information, he simply said that the decision to use the words “strong vigilance” was made prior to the recent market turmoil and they will determine what they will do on Sept 6th on that day. He added that the ECB never pre-commits on interest rates which clearly indicates that they haven’t decided what they will be doing either. Given the recent market turmoil, we think that all central banks with a hawkish bias will err on the side of caution and opt to forgo a rate hike for the time being. German and French banks have also fallen victim to the US subprime and credit crisis. To press forward with a rate hike may be too much for the European corporations to handle. The German IFO report is due for release tomorrow; business sentiment is expected to deteriorate.

Japanese Cabinet Shakeup Fails to Hurt the Japanese Yen
The Japanese Yen has strengthened across the board today on the back of US equity market weakness. Carry trades rebounded throughout last week and have now hit their exhaustion points. Many of the pairs hit technical resistance which has led to profit taking near current levels. News that Japan’s Prime Minister will be completely reshuffling his Cabinet amidst his low approval ratings has had a nominal impact on the Japanese Yen. Usually political uncertainty is not good for a country’s currency, but in the case of Abe, any change may be for the better. Twelve new appointments are expected to be made and only five ministers will retain their posts. Finance Minister Omi has been one of the Cabinet members to lose his job. Abe is expected to replace the Cabinet with veterans who have served under Koizumi, Abe’s predecessor. For the time being, the market’s risk appetite should continue to drive the movements of the Japanese Yen.

British Pound Pulls Back in Quiet Trading
The British pound pulled back against the US dollar and Japanese Yen but strengthened against the Euro in quiet trading. There was no data released given that UK markets were closed for holiday. Former Bank of England member Nickell, who is a dove suggested that the Bank of England could still raise interest rates this year. Although UK economic data has been steady, his comments hold little weight since the central bankers around the world have yet to decide themselves what to do with interest rates.

Australian Dollar Holds Steady While New Zealand and Canadian Dollars Underperform
It has been a while since we have seen a divergence in the performance of the commodity currencies. The Australian dollar strengthened today against the greenback while the New Zealand and Canadian dollars weakened. The latter’s performance is understandable since high yielding currencies all pulled back in lockstep with the Dow. There is little information on why the Australian dollar has rallied however. There will be a lot of Australian data due out later this week and perhaps some traders are expecting firmer numbers. Average hourly earnings are expected out of Canada tomorrow, but that figure is not typically a market mover.

Kathy Lien is the Chief Currency Strategist at FXCM.