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The November manufacturing ISM falls to a fresh 3 ½ year low at 49.5 from 51.2, in line with our forecast for a sub-50 reading following yesterday's sub-50 Chicago PMI. Our rationale for expecting the November ISM contraction stems from the historical behavior of long term rates' persistent stance above the fed funds rate as well as the recent acceleration in the rate of slowdown in ISM. We're not certain how and why forecasters arrived at a consensus estimate for a rebound in the manufacturing ISM when manufacturing jobs have shown net losses in 7 of the last 9 months of the monthly payrolls report.

Especially negative is the broadening contraction in the ISM subindices -- each of which remained or fell below 50, except for the prices paid and inventories. The rebound to 53.5 from 47.0 in the prices paid index may justify the Fed's inflation worries for now and could serve as the lone element for dampening early rate cut expectations. But this is not stopping FX traders from focusing on the deteriorating activity in the US, especially as both UK and Eurozone manufacturing PMIs remain well above 50.

As we noted yesterday, the sub-50 reading is proving powerful in raising chances of a Q1 rate cut (even after Bernanke's optimism), leading us to raise our expectations for a January rate cut from 50% to 55%. This also means that we lifted our chances of a Q1 rate cut to 95%, making the March rate cut the more certain outcome.

Dollar Sell-off Turns Violent

EURUSD hits fresh 20-month highs at 1.3347, as traders accumulate fresh fundamental reasons to buy dollars and sell euros. The sub-50 ISM is the catalyst and the 1.3420 is the next target for early next week. We expect the pair to extend gains as high as 1.35 this month before stabilizing towards the 1.3450s. Please see forecasts below.

The euro's rally extends across the board, damaging the commodity high yielding currencies of Australia and Canada . But the fact that the euro is now drops to 2 week lows against sterling, may start drawing the attention of British exporters.

Sterling shatters the $1.9770s to a fresh 14-year high at $1.9847, nearing our end of year target of $1.9880. Despite these gains in sterling, we do not expect the pair to attain the $2.00 due to emerging signs of weakness in the UK 's manufacturing sector and continued cooling in labor markets. Indeed, the Bank of England is now expected to raise rates by 25 bps to match US rates at 5.25% for the first time in a year. But the currency's gains vs both the dollar and the euro should help weigh on export growth and draw the attention of the BoE.

USDJPY assaults the 115.35 floor to hits a 3 1/2 month low of 114.99 The pair should now be heading towards our year end target of 114 even if it is increasingly clear that the Bank of Japan will not raise rates this year.