Fed Rate Decision Will Determine Fate Of US Dollar, Dow, And Carry Trades

Producer Price Index (YoY) (AUG) (08:30 EST; 12:30 GMT)
Expected: 3.2%
Previous: 4.0%

FOMC Rate Decision (14:15 EST; 18:15 GMT)
Expected: 5.00%
Previous: 5.25%

How Will The Markets React?

Tuesday, September 18th is the day that forex, bond, and equity traders have been waiting for since mid-August, as the Federal Open Market Committee will meet and announce their interest rate decision at 14:15 EST. At this point, it is no longer a question of whether or not they will cut, but by how much. Currently, Fed fund futures are pricing in a 54 percent chance of a 50bp cut against a 46 percent chance of a 25bp cut. On the other hand, the percentage of economists polled by Bloomberg expecting a 25bp cut has jumped to 78 percent from 69 percent from just a week ago, while only 18 percent expect a 50bp cut, down from 21 percent. So who will be proved correct: the markets or economists? More importantly, is there a chance that the Fed will actually do the unexpected and leave rates unchanged in fear of moral hazard? In reality, Bernanke & Co. will probably be more concerned about recession risks. Furthermore, this rate decision has been built up so much that anything less than a 25bp rate cut has the potential to send equities and forex carry trades plummeting, while the US Dollar would likely rally sharply against currencies like the Euro and British Pound. Conversely, with the markets pricing in a 50bp cut, a 25bp cut may only receive a mild reception in the forex and equity markets, with carry trades and the Dow likely to end the week little changed. Regardless, Tuesday promises to bring substantial volatility and a break away from range trading.

Bonds - 10-Year Treasury Note Futures

The decline in 10-year Treasury notes over the past few days has been slow and steady, and if the contract can hold initial Fib support at 109-07, price could rebound higher into the 111-15 area. Any prolonged price action below the 109-07 support level, however, will damage the overall bullish bias, leaving Treasuries to target trendline support at 108-31. Event risk stemming from the FOMC rate decision could throw bond traders a curve ball, with a 25bp cut unlikely to inflict much damage. However, if the central bank goes with a sharp 50bp cut, Treasuries are likely to rally in response, while the decision to leave rates unchanged at 5.25 percent would send the contract diving lower

FX - EUR/USD

With EURUSD still trading near record highs around the 1.3900 level, many traders have been left wondering how much lower the greenback can possibly fall. Given the ramped up speculation regarding the possibilities of a rate cut by the Federal Reserve on September 18th, targets of 1.3950 and 1.4000 do not seem unreasonable. However, how quickly the pair will move depends on how sharply the central bank cuts rates. While volatility and wild price action will run high regardless of the actual decision, a 25bp cut may only elicit a mild reaction, especially as the bond markets are increasingly pricing in a 50bp cut. As a result, a mere 25bp cut will likely lead EURUSD to jump higher initially, but the pair could slowly deflate thereafter, especially if there are no signs that additional rate cuts loom on the horizon. On the other hand, a 50bp cut will send the pair rapidly rocketing to test the recent record of 1.3926 and possibly even higher to take on trendline resistance (dating back to June 2006) at 1.3970.

What if the Federal Reserve does the unexpected and leaves rates unchanged? This would prove to be most perilous for the equity markets, but the shake up would also lead to a major bout of risk aversion, leaving traders flocking away from stocks and carry trades (such as EURJPY and EURJPY) into Treasuries and the US Dollar. Initial support for EURUSD sits at 1.3842, but declines for the pair would likely be far more severe, and a move down to trendline support at 1.3700 would not be out of the question.

Equities - Dow Jones Industrial Average

The Dow edged back on Monday from the confluence of the 100 SMA and Fibonacci resistance at 13,423/47, ending the day down 0.29 percent at 13,403.42. The Federal Reserve’s rate decision on Tuesday was be of critical importance to where US equities go next. Currently, the markets are expecting at least a 25bp rate cut - if not 50bp - and anything less has the potential to send the Dow spiraling lower as investors will consider the next step to be a recession and an all-out credit crunch. Such a move would also send forex carry trades such as EURJPY and USDJPY plummeting, with the former remaining a relatively accurate barometer of risk appetite market-wide. Fibonacci support for the Dow looms below at 13,121, while sharper declines could target the psychologically important 13,000 level and the 200 SMA at 12,951.

At the other extreme, equity traders may be overjoyed if the Fed moves to cut rates by 50bp, as the decision would signify that Bernanke and Co. have no fear of moral hazard and will be looking to prop up the markets in times of distress.

The most likely scenario? The central bank will likely take a slow and steady approach, cutting rates by 25bp in light of the worsening housing collapse and its possible impact on economic expansion. The Dow may only show a mild gain in response, leaving the current range of 13,000 - 13,500 intact.


By DailyFx

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