ECB Rate Decision: 3 Possible Outcomes, Expect a Break in the Euro
The disturbing weakness of today’s US economic data has distracted everyone from the second most important event risk this week, which is tomorrow’s European Central Bank interest rate decision. Typically the ECB likes to let the market know at least a month in advance what they plan on doing with interest rates. This time however, Trichet and company will have traders guessing up to the last second. There are three potential outcomes of this much anticipated rate decision. The first and the most unlikely is if the ECB raises rates to 4.25 percent. This surprisingly hawkish move would be extremely positive for the Euro, taking the currency pair back above 1.3700. The second scenario is for the ECB to leave rates at 4 percent, drop the words strong vigilance and add some other dovish comments that would allude to interest rates remaining unchanged for the remainder of the year. This would be extremely bearish for the Euro, taking it back below 1.3550. The third scenario would be for the ECB to leave interest rates unchanged and make convoluted or slightly hawkish comments (which may or may not include the words strong vigilance and in essence leave the door open for further rate hikes. In this case, the reaction in the Euro should be limited. Given the recent move in European bond yields, the ECB really has no choice but to leave interest rates unchanged. Economic data has been mixed while inflation pressures have been modest. The only area of concern is the financial markets and how much damage US subprime losses may have had on the German banking sector. Expect tomorrow’s rate decision to take the Euro out of its 1.3550 to 1.3680 trading range.

US Dollar Loses Flight to Safety Status on the Weight on Weaker Data
The Dow plunged 150 points today, taking carry trades down with it. Economic data was very weak, foreshadowing even more difficult times ahead for the US economy. Over the past few weeks, we have seen the dollar rally on weak US economic data because both domestic and international traders flocked to the safety of US treasuries. However the lack of a rally in the currency today suggests that the US economic outlook could be so poor that even international traders are looking to parking their money elsewhere while domestic traders are just moving back into cash. The US 3 month LIBOR rate rose for a 10th day in a row, reaching new 6 year highs. Not only does this mean that lenders are unwilling to offer cash for any time longer than a few days, but it also means that consumers and businesses will become more strained in the months ahead since the rate affects everything from adjustable rate mortgages to floating rate bank loans. For this reason alone, the Fed will need to cut interest rates. But on top of that, today we saw pending home sales drop 12 percent in the month of July while the ADP employment survey increased by a pathetic 38k, well below the market’s 80k forecast. Taken together with the 6.6 point drop in the Hudson employment index, it will be difficult for non-payrolls to break the 100k mark. Even though the stock market and carry trades extended their losses after the Beige Book report, the release was actually quite mild. The various Fed districts reported a slowdown in the housing sector but outside of that, the impact of the turmoil in the financial markets has been limited. Rate cut expectations have increased today. Tomorrow we have service sector ISM due for release and we will be looking at the employment component of the report for more information on how Friday payrolls will fare.

Australia Looks Ahead to Employment Report, Bank of Canada Moves Policy to Neutral
The Bank of Canada left interest rate unchanged at 4.50 percent and removed their bias to raise interest rates again this year. More specifically, the BoC indicated that even though growth has been stronger than expected in Canada and domestic demand could remain strong, they fear that the sharp US housing downturn and weaker growth outlook could spillover into the Canadian economy. This along with news that the Canadian Prime Minister has suspended Parliament sent the Canadian dollar tumbling against the US dollar. IVEY PMI is due for release tomorrow. Canadian economic activity is expected to remain strong. Meanwhile, the New Zealand dollar continued to suffer the biggest loss in the currency market. The kiwi is down 1.35 percent against the dollar and 2.16 percent against the Japanese Yen, indicating that risk aversion remains high. The Australian dollar on the other hand saw far a milder loss ahead of their employment report. The labor market should remain tight as the pace of job growth accelerates.

Bank of England Not Expected to Change Interest Rates
The Bank of England is expected to leave interest rates unchanged at 5.75 percent and unlike the ECB, when they do not tinker with interest rates, there are no comments made. Economic data has been hot and this will continue to buy the Bank of England time even though they too are becoming increasingly concerned with the moves in the bond markets. Three-month sterling rates jumped to an 8.5 year high, raising speculation that the Bank of England may have to inject liquidity into the financial markets if borrowing costs continue to rise. Like the manufacturing and construction sector ISM reports, service sector ISM in August was particularly strong.

Carry Trades Rally, but Move is Unconvincing
Yesterday, we had said that even though carry trades rallied, the move was unconvincing because the New Zealand dollar did not participate in that rally. Today, we see all of the gains made on Tuesday erased. Carry trades continue to remain vulnerable as stock markets around the world weaken. The Nikkei was down 1.6 percent overnight. Further weakness tonight will result in additional losses for the Yen crosses. According to MoF official Watanabe, the Japanese are now also worried about US contagion.

Kathy Lien is the Chief Currency Strategist at FXCM.