As US equity futures plunge 4-5%, posting their lowest pre-open slide since the first day of trading after September 11, 2001, we evaluate the possibility for the Bank of Canada and the Federal Reserve to mount a joint injection of liquidity aimed at calming dislocated markets, whereby the Bank of Canada makes a bigger than expected 50-bp rate cut to 3.75% at its scheduled policy meeting this morning. An aggressive BoC cut coupled with another dosage of coordinated injections by the Fed and European Central Bank may be one of the remaining measures available to the central banks in delivering any effective support to the current market turmoil. Despite resurfacing speculation of an inter-meeting Fed rate cut in light of the 4-7% declines in Asian and European indices, the possibility of such action has markedly diminished because the FOMC’s scheduled rate announcement stands only eight days away. A 75-bp rate cut by the Fed next week would be more effective in dealing a shot in the arm to eroding market confidence than an incrementally smaller easing this week and the following week, which raise speculation of a hasty central bank chasing market confidence and psychology.

Bank of Canada May Surprise with 50-bps

This morning’s BoC announcement (9.00 am EST) is widely expected to produce a 25-bp rate cut to 4.00%, but the intensifying sell-off in Canadian equities, coupled with the looming risk of a US recession dragging Canada’s economy into a more protracted slowdown and increased resistance by commercial banks to cut their prime rate may prompt the BoC to opt for a deeper rate cut. A more aggressive 50-bps rate cut to 3.75% would likely maintain Canadian rates equal to their US counterpart after a much anticipated 50-bp move by the Fed next week. In order to hedge itself against the risk of renewed CAD strength emerging from deeper US rate cuts and a possible rebound in oil prices, the BoC will may consider the bigger option. The main fundamental obstacles to such a move are falling unemployment rates and rising consumer spending.

But traders will also watch the 8.30 am release of Canadian retail sales, expected to have risen by 0.3% in November from 0.1% in October while ex-auto sales seen up 0.5% from unchanged. The report can play a major role in determining volatility in the loonie, with a weak figure likely to increase the odds for a half a point move half an hour later. The last time the BoC cut rates by 50 bps was in November 2001.

Yet, even in the event of a 25-bp rate cut, we expect any CAD upside to be limited as the central bank issues a gloomy statement, which will open the door for one more easing in March. The key positive for the CAD is more likely to be a surprise announcement from the Fed.

Most notably, USDCAD broke above its 200-day MA yesterday for the first time since April 2007. Upside capped at 1.0370, followed by 1.0390. Downside is more likely to emerge on a negative market interpretation of the BoC decision and/or an improvement in risk appetite, possibly resulting from a coordinated intervention between the BoC and Fed.

Yen Soars as Risk Appetite Takes Over from Fundamentals

Yen extends gains to 2 ½ year highs versus the USD and GBP, as the intensifying unwinding of yen carry trades overwhelms any negative yen fundamentals from the increasingly shaky Japanese economy. The Hang Seng and Nikkei-225 plunged 8.7% and 7.6% respectively, accelerating the sharp reductions in risk appetite and the resulting rally in the yen.

With the Bush Administration’s economic stimulus package failing to impress and the absence of Fed inter-meeting rate cut raising erasing hopes of a shot in the arm to damaged markets sentiment, markets will turn to the 8.00 am EST speech by US Treasury Secretary Paulson.

Yen longs are warned of any sharp yen declines in the event of significant liquidity injections by central banks and/or an unexpected rate cut from the Fed. We do not expect a speech by a US policy maker will boost market confidence at a time when the joint injections of liquidity by the Fed, ECB, BoE and BoC back failed to sustain confidence in Dec 12.

Upside seen capped at 106.60, with the risk of any central bank action likely lifting the pair to as high as 107.80. Support stands at 105.80, followed by 105.20.

AUDJPY sees support at 90, followed by 88.40. Watch out from the 7.30 pm twin releases of Q4 GDP and CPI, with the former expected up 1.0% q/q from 0.7% and the latter slowing to 2.8%.

Euro En Route to $1.43

The euro struggle turns into damage amid increasing speculation that the European Central Bank may be forced swaying its policy bias towards reinvigorating growth in light of possible write-downs at French banks and German housing entities. We mentioned on Friday the euro would make way for testing the 1.46 support amid increased speculation that the ECB is transitioning into a less hawkish stance despite their repetitive pronouncements. On Monday, EURUSD tumbled nearly 2 cents to a 4-week low of $1.4360 before stabilizing at $1.4470. We stick with our $1.43 month-end target for the pair. Due to losses in US equity futures of as much as 4%, the possibility of an intervention from US authorities may prompt a temporary recovery in the pair. But increased signs of troubled banks in the region are likely to prompt the market into punishing the euro due to the ECB’s persistent hawkishness. Upside is seen limited at $1.4525. Key resistance stands at 1.4570.

Sterling’s beaten by worst of both worlds

Sterling is damaged by a combination of carry unwinding hitting the high yielding currency and particularly dismal UK fundamentals. The latter is underlined by Friday’s unexpected 0.4% decline in retail sales, which was the biggest decrease in a year. Upside capped at 1.9580, followed by 1.9620, with any protracted gains likely to be exploited by an increasingly bearish market stance towards the currency. Support starts at 1.9460, followed by 1.9400.