The US dollar came within a hair of 1.3855, its all-time record low against the Euro. By the end of the week we expect to see either see a new record low or a double top. Over the past five trading days, the US dollar has not seen one positive day as the concerns about the US economy continue to grow. At this critical juncture, the primary question on everyone’s mind is, “Will the US dollar continue to fall?” Although 1.3850 is a significant resistance, we think that this level will be reached once again and it is just a matter of time before it will be broken. The 185 point rally in the stock market indicates that equity traders expect nothing less than a quarter point rate cut from the Federal Reserve and even that may be seen as a disappointment. The consequence of not lowering interest rates is one of the biggest reasons why the Fed will have to deliver exactly what the market wants. If they leave rates unchanged, we would see an entire repricing of the yield curve and the stock market collapse. In the event of a rate cut, the dollar is expected to fall because lower interest rates will prompt investors to start looking outside the US for opportunities to earn higher yield. The interest rate cut by the Fed will only be the beginning of more easing. The yield curve is pricing in 3 interest rate cuts by the end of the year and some analysts are even calling for as much as 125 basis points of easing before the Fed stops. Therefore, the pressure on the dollar will come not from the actual lowering of interest rates on September 18, but instead from the expectations that rates will fall even further. This puts the Fed’s monetary policy in stark contrast with the policies of the European Central Bank, Bank of England and Reserve Bank of Australia, all of which are keeping interest rates steady and holding onto their hawkish monetary policy biases. The trade balance was the only piece of US data released today and the slightly weaker report had a limited reaction on the currency market. There is no significant data today or tomorrow which leaves retail sales on Friday the primary focus for the remainder of the week.

ECB Trichet’s Comments Help Take Euro Towards Record Highs
It is not hard to understand why the Euro has been so strong over the past few days. Here we have Bernanke skirting comments about the economy and monetary policy and across the pond ECB President Trichet is reassuring the markets that their expectations for growth have not changed and recent inflation risks leave the door open for another rate hike this year. As long as the market expects the Fed to lower interest rates and the ECB to stand pat, the Euro has a greater chance of reaching 1.40 than 1.35. The rise in gold prices today further suggests that traders are beginning to price in the possibility of a recession. There was no major Eurozone economic data released overnight. Eurozone industrial production is the only piece of data due out tomorrow.
Manufacturing activity is expected to be stronger, which should help keep the bid tone under the Euro. The only problem is that the Euro may not be able to break 1.3855 on its first test.

Canadian Dollar Heads Towards 30-Year Highs
After consolidating for the past month, USD/CAD fell over 100 pips today to hit a new 6-week low on the back of higher oil prices and stronger housing numbers. The technical break puts 1.0340, the 30 year low for USD/CAD in scope and there is a strong chance that level will be challenged over the next few days. Bank of Canada Dodge is scheduled to speak tomorrow, but we do not think that he will diverge much from the topic of “Transparency.” Housing starts increased a whopping 5.1 percent to 226.5k in August while new housing prices increased 0.9 percent in July. This offset any concerns that may have stemmed from the weaker than expected trade surplus for the month of July. The New Zealand and Australian dollars also performed extremely well today. Both currency pairs are up over 1 percent thanks to much stronger gold prices and a renewed rally in US stocks. The Reserve Bank of Australia will be releasing their annual report tonight and Australia also has consumer confidence due for release. New Zealand on the other hand only has food prices. The RBNZ rate decision and retail sales are not until Thursday.

British Pound Shrugs Off Softer Data
A larger than expected trade deficit and weaker than expected leading indicators in the month of July has mattered little to a market that is focused primarily on interest rate expectations. So far, the downside surprises in UK economic data have not been bad enough to force the Bank of England to take action. The outlook for the US economy is far worse than the UK economy even though Britons have their own bubble troubles.
However tomorrow, the British pound will be in play. Claimant count and average earnings are due for release. The number of people filing for unemployment is expected to drop and average earnings growth is expected to accelerate. An upside surprise in the employment report is worth three times the downside surprises that we have seen thus far. The labor market is a critical part of any economy and if that remains stable, the central bank has far less to worry about.

Carry Trades Rebound but are Still Range Bound
Carry trades rebounded strongly today thanks to the rally in the Dow. However, before getting too excited, a closer look at charts of the Japanese Yen crosses reveal currency pairs that still remain below their late August highs. Also these pairs are within a wide range which suggests that even though a further recovery is likely, the gains will be limited. USD/JPY for example rebounded to 117.13 after hitting a low of 111.60 on August 17. Therefore, any rebound in USD/JPY should taper off before it reaches that same level.

Kathy Lien is the Chief Currency Strategist at FXCM.