Will Bernanke Bow to Political Pressure? 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 dollars 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 dont, 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 Englands 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.

DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com

FXCM, L.L.C.® assumes no responsibility for errors, inaccuracies or
omissions in these materials. FXCM, L.L.C.® does not warrant the
accuracy or completeness of the information, text, graphics, links or
other items contained within these materials. FXCM, L.L.C.® shall not be
liable for any special, indirect, incidental, or consequential damages,
including without limitation losses, lost revenues, or lost profits that
may result from these materials. Opinions and estimates constitute our
judgment and are subject to change without notice. Past performance is
not indicative of future results