Pivotal day ahead with Fed rate decision at 1915 GMT

Watch monetary policy statement guidance and the adjustment to the discount rate - as Fed likely to cut Fed funds rate 25 bps.

MAJOR HEADLINES – PREVIOUS SESSION
Overnight developments:

• Australia Nov. NAB Business Confidence fell to 6 from 9 in Oct.
• China Nov. CPI rose 6.9% vs. 6.5% expected
• New Zealand Nov. House Sales fell -21.6% YoY vs. -22.6% drop in Oct.
• China Nov. Trade Surplus out at 26.28B vs. 26.55B expected and 27.05B in Oct.
• Japan Nov. Consumer Confidence fell to 40.00 vs. 43.0 expected.

THEMES TO WATCH – UPCOMING SESSION
Key event risks today (all times GMT):

• Sweden Nov. CPI (0830)
• EU ECB's Liebscher to speak (0900)
• Sweden Nov. AMS Unemployment Rate (0900)
• UK Oct. Visible Trade Balance (0930)
• Germany/EU Dec. ZEW Survey of Economic Sentiment (1000)
• US Fed Rate Announcement (1915)
• US ABC Weekly Consumer Confidence (2200)
• Australia Dec. Westpac Consumer Confidence (2330)
• Japan Nov. Domestic CGPI (2350)
• Japan Oct. Current Account (2350)
• US Treasury Secretary Paulson makes statement in China (0115)
• China Nov. Retail Sales (0200)

Market Comments

It looks as if the US equity markets are really gunning for the Fed and the US government to make things right again as equities continued their strength yesterday. The latest cause of cheer was an announcement that Warburg Pincus would inject USD 1 billion in the trouble bond insurerer MBIA, which along with the likes of Ambac, has been in desperate trouble lately as it looks for a liquidity injection. We also have the subprime bailout plan generating plenty of hubbub. (Again, we are extremely dubious on whether this plan can bring any real salubrious effect to the mortgage market). These developments of course had the JPY crosses off to the races to the upside once again.

The fixed income market is telling a confusing story - the panic levels seem to be easing as the US 2-year index has risen in a straight line over the last week from about 2.80% at the nadir to over 3.15% yesterday. But if we look at the spread to Libor at the short end of the curve, there is absolutely no sign of an easing in bank's liquidity problems and tight credit conditions, as the Fed's effort so far have shown absolutely no signs of easing the situation. Look, therefore, for the Fed to get a bit more aggressive on the discount rate side of the equation as we mentioned yesterday. (some even looking for the fed funds rate and discount rate to move into parity vs. current 50 bp spread) Again, for the Fed funds rate, the high odds scenario is for a 25 bps cut, with a sizeable minority looking for a 50 bp cut. Also focus on the monetary policy statement, where last time the growth vs. inflation risks were described as "roughly balanced". If we get a tilting of this part of the statement the one way or the other, this could be what the market reacts most sharply to. A shift to the dovish side could have the USD testing the recent lows. Let's see where thing stand tomorrow in the aftermath, but right now the risks seem tilted to a try at the highs in EUR/USD. Watch the 1.4750/75 shoulder area as this is the last area barring further upside.

One interesting note from PBOC comments overnight as Zhou pointed out that China monitors the trade-weighted Yuan, not just the US dollar. This is a clear reference to the absurdity of the CNY falling so much vs. the EUR over the last year. Could this put a lid on some of the EUR strength eventually?

Chart: AUDCAD and EURCHF

AUDCAD: Here's a trade that keeps us away from the USD volatility around the Fed rate decision. Australian rates look steady for now at 6.75% while it appears the Bank of Canada has begun an easing cycle now that it has cut rates for the first time. The Canadian economy has also historically been heavily linked to the US economy, though many would argue that its resource extraction industries have changed the equation a bit for Canada. Still, the rate outlook and the gold/oil ratio favor AUDCAD higher - and a break of the flatline resistance at 0.8900 could lead to sharp further gains in the weeks ahead.

EURCHF: Is this the real thing or is it a false break? We watch in awe as the market is still hungry for risk and this classic barometer of risk appetite breaks to new highs (and is breaking the 55-day SMA in red) ahead of the Fed meeting. With the huge risks to the economy from this ongoing credit situation, we have a hard time telling a story that supports further upside here. But we don't like to pick highs and lows, but would rather express a view with options. 1-month EURCHF put options, anyone?