The Dow is up 91 points on the first day of trading in September and in the third quarter. Although this has helped to lift carry trades, the US dollar’s rally against the Euro and British pound as well as the mixed performance of bond yields suggests that the financial markets have not turned suddenly optimistic. US economic data was weak with both manufacturing ISM and construction spending falling short of expectations. Activity in the manufacturing sector was the slowest in 4 months while construction spending was the lowest in 7 months. Even though vehicle sales were stronger than expected the Dow is higher today for no other reason than the fact that the market expects the Federal Reserve to cut interest rates later this month. A 25bp rate cut has been fully priced in and there is a 58 percent chance of a half point cut. Although the markets have been calling for the Federal Reserve to lower interest rates for months now, this would still be the first time in over a year that the Federal Reserve has actually altered their lending rate. Another reason why the rally in carry trades may not continue is because September tends to be a difficult month for the Dow. Over the past 50 years, the Dow has had an average return of -1.35 percent from the beginning to the end of the month. If the relationship between carry trades and the Dow continue to hold, then that would mean a difficult month for carry trades as well. The Challenger layoffs report and ADP employment survey are due for release tomorrow along with the Beige Book report. For those who are not convinced that the Fed will lower interest rates, and there are a decent amount of people who still don’t, the labor market reports this week could be the deciding factor. Congress has returned from Summer Recess and we expect a lot of finger pointing over the next few months. They will be looking for someone to blame the subprime and credit debacle on as well as pressuring the Federal Reserve for solutions. The fact that Senator Dodd and not the Fed Chairman was the first to tell the markets last month that the Federal Reserve has pledged to use “all tools available” to avert a housing and credit crisis suggest that Bernanke will act in a way that will please the consensus later this month. For the time being however, the Federal Reserve will probably remain on the fence until more economic data is released.

Reserve Bank of Australia and Bank of Canada Both Expected to Remain Hawkish
The Reserve Bank of Australia and Bank of Canada will be the first central banks to announce their interest rate decisions this week. For the RBA, the announcement will be easy since there is zero chance that they will be changing their interest rate and when they fail to do so, no statement is released. This will make the RBA announcement a nonevent even though the central bank could still raise rates before the end of the year. The Australian dollar is the only major currency to have strengthened against the dollar today and that was because second quarter GDP increased 0.9 percent, bringing the annualized pace of growth to 4.3 percent, the fastest in 3 years. The Bank of Canada on the other hand has a much more difficult job. Although they too are expected to keep rates unchanged at 4.50 percent, firm GDP growth and continued inflationary pressures could keep the BoC hawkish. The Bank of Canada will have to decide whether that is more important or the risk of slower US growth taking its toll on the Canadian economy. Meanwhile the New Zealand dollar has seriously underperformed today despite the lack of any economic data. Read the carry trade section for more details.

British Pound Rally Comes to an End Despite Strong UK Economic Data
After rallying against the Euro for four days straight, the British pound finally gave back some of its gains despite continued strength in economic data. Not only did retail sales pick up last month, but construction spending also hit a 9 year high. For the time being, the UK economy seems to be relatively immune to the problems in the US. Strong consumer spending as well as a stable housing market justifies the Bank of England’s lack of concern about the recent volatility in the financial markets. The central bank can continue to remain hawkish as long as there is no major pullback in the UK economy. Service sector PMI is due for release tomorrow. Given that activity in the construction sector is at a 9 year high and activity in the manufacturing sector is at a 3 year high, there is a good chance that service sector activity could be strong as well.

Euro: Stuck in a Range Until ECB Rate Decision
Although the Euro weakened slightly against the US dollar today, we expect the currency pair to remain mostly range bound ahead of the ECB interest rate decision. Producer prices were slightly stronger than expected in the month of July, but since the annualized pace of growth is still below 2 percent, it should not cause that much concern for the ECB. Instead, Trichet and company will have to consider how widespread the problems in the financial sector are at the moment. There is talk that more German banks will report large subprime related losses. Meanwhile second quarter Swiss GDP growth was stronger than expected. This is the first time in a while that we have seen firmer Swiss reports. We expect the central bank to follow in the footsteps of the ECB, meaning that if the ECB stays on rates, the SNB will too.

Carry Trades Rally, but Move is Unconvincing
All of the Japanese Yen crosses are higher today with the exception of NZD/JPY which tells us that risk aversion could still be a dominant factor in the financial markets. As the poster child of carry trades, the move in the New Zealand dollar should not be ignored. Furthermore the lack of a cohesive move in bond yields and the price action in the New Zealand dollar tells us that even though carry trades could move higher overnight, the rallies today are unconvincing, so watch out for a return to weakness.

Kathy Lien is the Chief Currency Strategist at FXCM.