By all measures, the U.S. economy is slowing. The yield curve has been inverted for some time now. U.S. Gross Domestic Product fell to 1.6% in the third quarter of this year, well below historical growth levels for the U.S.

Given the slowing economy, an intelligent assumption would be interest rates will decline soon to spur the economy. But not so fast... there’s another part to the story.

Over the past few months, the U.S. dollar has been declining sharply in value against other world currencies. The euro has been the biggest benefactor of the U.S. dollar fall. Here’s the scenario that’s unfolding in the currency market and how it affects interest rates and your investments:

It’s well known in the financial markets that the U.S. dollar has remained strong over the past couple of years because interest rates in the U.S. were amongst the highest of the G7. Money moves to where it earns the highest return. And, much to the dismay of many investors who were betting the U.S. dollar would fall over the last couple of years (people such as Warren Buffett), the dollar stayed strong because interest rates in the U.S. were brought up so high, beginning in the summer of 2004.

Now, the markets understand just how slow the U.S. economic machine is turning. Many traders are betting the U.S. Federal Reserve will lower rates to spur its economy, thus making U.S. bonds less attractive to foreign investors.

Thus, the most important unanswered question today about stocks and the U.S. economy: Will the Fed lower rates in 2007 to avoid a domestic recession or will it decide to keep rates high or higher to protect the status of the U.S. dollar as the world’s reserve currency? After all, is the U.S. government not dependent on foreigners buying its bonds to finance its growing debt?

While there are think camps lining up on both sides of the bet, either move the Fed makes will be negative for popular stock averages like the Dow Jones Industrial Average, the S&P 100 and S&P 500. If interest rates stay the same or move higher, stocks will suffer because at a point the return on fixed income instruments (U.S. bonds and treasuries) will be more attractive than overvalued U.S. stocks. If interest rates decline to spur the economy, the value of the U.S. dollar could be sent into a tail spin, rattling large U.S. corporations that deal internationally and rattling the stock market as well.

The Fed’s placed itself in one of those unpleasant “you’re damned if you, damned if you don’t” situations.

NEWSFLASH--Foreign exchange analysts at BNP Paribas SA of France came out this weekend with a report saying they expect the U.S. Fed to lower interest 150 basis points in 2007 as it deals with the slowing U.S. economy. BNP expects this move to send the U.S. dollar into a tailspin. Hence, BNP is of the opinion the Fed would rather see the U.S. dollar fall dramatically on world currencies rather than see the U.S. economy continue slowing. For one, I’m not so sure I agree with BNP about what the Fed’s priority will be... not just yet.