By DailyFX – ECB Rate Decision: 3 Possible Outcomes, Expect a Break in the Euro. The disturbing weakness of todays… … US economic data has distracted everyone from the second most important event risk this week, which is tomorrows 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 tomorrows 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 markets
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.

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

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