With the clock ticking until the all-important Federal Reserve interest rate decision at 14:15 EST on October 31, traders are quickly upping the ante and betting that the central bank will be cutting rates on Halloween. Currently, Fed fund futures are pricing in a 98 percent chance of a 25 basis point cut to 4.50 percent and a 2 percent chance of no change, but forex and equity traders have been cautious amidst the completely divergent speculation that the FOMC could also show the markets some tough love by not cutting rates at all or cutting them by 50bp to put an end to any further easing. In fact, 30 percent of the economists polled by Bloomberg believe the bank will keep the benchmark lending rate at 4.75 percent.

This helps to explain why the Dow Jones Industrial Average currently trades little more than 100 points higher than it did on September 18th – the last time the FOMC cut interest rates. Forex carry trades like EURJPY and GBPJPY have fared slightly better as the market became more risk-seeking, though the pairs are down from their October 15th peaks. As for the US dollar, shifting rate expectations have put the currency on a rollercoaster ride to new lows. A month ago, Fed fund futures were pricing in an 84 percent chance of a 25 basis point cut, but two weeks later, probabilities fell to just 38 percent. Since then, probabilities are back up to 95 percent, pushing the greenback to all time lows against the Euro, 47-year lows against the Canadian dollar, and 13-year lows against the Australian dollar. With these currency pairs trading at such extreme levels, a major event risk could trigger a sharp and sudden turn. Will this week’s FOMC rate decision do the trick?

Economic conditions in the US are looking increasingly shaky. Corporate profitability has been mixed and warnings of more difficult times have been issued by many. While consumption growth actually improved recently, consumer confidence and personal income figures have actually fallen back. Sentiment has been hurt by the threat of rising gasoline prices as crude oil pushed to fresh record highs above $93/bbl, while housing market indicators consistently show that the sector has yet to bottom out. True, pending and new home sales both reflected stronger readings recently, but those interpretations are all relative. Pending home sales were still down sharply and the index actually plummeted to 85.5 – the lowest reading since records began in 2001. Likewise, new home sales only looked positive in September because the August reading was revised down so drastically. Since the index only counts contract signings rather than closings, a pick up in cancellations could easily drag the headline figure lower in subsequent months. Meanwhile, a surprisingly solid non-farm payrolls report reflected a brighter outlook for the labor markets, even though the unemployment rate still ticked up towards the top of the Federal Reserve’s expected range of 4.5 – 4.75 percent. However, this Friday’s round of revision-prone NFP readings may not be as rosy.

Whether the dollar will rise or fall on Wednesday will be dependent not only upon the actual policy decision but also on how bad the Federal Reserve thinks the housing market is doing as well as whether they believe that “some inflation risks remain.” Headline consumer and producer prices were both up in the month of September and based upon the recent increases in energy and food prices, the Federal Reserve is not likely to loosen their leash on inflation. However, some FOMC members have touted the importance of core inflation measures as a better gauge for monetary policy, and with these readings recently proving to be softer, the central bank may not rush to cite price pressures as a predominant concern.

It’s All Or Nothing: 25bp vs. 0bp

There are four possible outcomes for this Wednesday’s interest rate decision. The first would be to cut interest rates by 25bp, which is the highest probability scenario. The second is to leave rates unchanged, the third is to just cut the discount rate and the fourth would be to cut rates by 50 instead of 25bp. The last case scenario is the least likely given the reluctance of Federal Reserve officials to vocally support even a 25bp rate cut. Economic conditions have not deteriorated enough o warrant a back to back cut of 50bp.

Given the feeble condition of the US economy, and the even more fragile outlooks, Fed futures show that traders are feeling increasingly assured that they will see a 25 basis point cut as the consequences of unchanged rates would be severe. The entire yield curve would be re-priced and the stock market would collapse. To add further confusion to the mix, a recent paper published by Federal Reserve Governor Frederic S. Mishkin suggests the potential for only a cut to the discount rate, rather than the Fed funds rate.

25 Basis Point Cut

As we mentioned above, many consider a 25 basis point interest-rate cut in October a done deal, but what about a more dramatic cut? At the time of writing, Fed Fund futures reflect no chance of a half-point cut to 4.25 percent while only 4 of 102 economists polled by Bloomberg foresee this kind of policy action. Given the hot headline inflation figures we’ve seen lately and signs that price pressures continue to mount, the Federal Reserve is highly unlikely to go through with such a drastic cut. However, a 50 basis point reduction would be the most bullish move for the equity markets and most bearish result for the greenback, and as a result, a 25 basis point cut in line with expectations may only support indices like the DJIA and S&P 500 for so long as credit conditions remain tight. The US dollar, on the other hand, could remain bearish in the near-term, but that will be dependent on any bias reflected in the policy statement. Should the statement remain unchanged and neutral, alluding to the fact that the rate cut was nothing more than preemptive, the dollar could remain supported until Friday’s non-farm payrolls report.

No Fed Fund Rate Cut…25 Basis Point Cut To The Discount Rate?

What if the FOMC does the unexpected and leaves the Fed funds rate unchanged? Of the 102 economists polled by Bloomberg, 32 predict that the central bank will opt to hold off on any additional policy actions until December. Such a move would prove to be disastrous for the US equity markets and could send the DJIA plummeting towards the August lows, while the US dollar would finally regain a bid tone to turn pairs like EUR/USD away from their record highs.

Is there a way for the FOMC to pause and avoid such dramatic price action? Possibly, and Federal Reserve Governor Frederic S. Mishkin brought it up in a paper published on October 26th. In it, he discussed the issue of the Federal Reserve’s interest in financial stability, and that it is not “out of a desire to aid distressed investors or institutions,” but rather the “intimate connection between a stable financial system and solid macroeconomic performance.” Mishkin also mentioned the risk of moral hazard, especially in regards to injecting liquidity into the markets, which he calls a “key tool for the Federal Reserve in its quest to achieve its statutory objectives of maximum sustainable employment and price stability.” Another tool Mishkin touted was the discount window, which “allows banks in sound financial condition to borrow at will at a rate above the target federal funds rate.” However, this penalty rate may prevent banks from borrowing to extend loans to troubled sectors. As a result, “lowering the discount rate may also help underscore the central bank's intent to provide adequate liquidity to promote the functioning of financial markets.” Furthermore, “having a discount facility at its disposal provides a central bank with a more targeted tool for coping with financial disturbances without promoting inflationary tendencies.”

Is this the magic formula? Will the FOMC decide to forego a cut to the Fed funds rate and instead knock the discount rate down? This sort of policy action has the potential to allow the US stock market bubble to deflate rather than collapse, while also giving US dollar bulls reason to come back into the forex markets. Nevertheless, traders should count on a spike in volatility on the announcement of any policy decision and sustained weakness in the US dollar as long as the Fed is expected to cut rates again. Furthermore, the markets should keep an eye on the FOMC statement.

FOMC Statement: Lines to Watch

When looking at the FOMC statement, the market typically looks for every new word that has been included and excluded from the statement. In the last meeting, there were just a handful of changes. The Fed continued to acknowledge that there was weakness in growth in the “first part of the year” but also noted the major risks associated with the tightening of credit conditions and the bank’s intent to be proactive and prevent an all out recession. Going forward, the combination of a weak dollar and high average gasoline prices may give the Fed no choice but to reflect at least a slight inflation bias. Although the collapse of the housing sector and tight credit conditions still warrant cautionary comments, the Fed may move to note improvements in the credit markets. The futures curve is pricing in a 67.2 percent chance of a 25 basis point cut to 4.25 percent in December, and if the Fed’s statement proves to be dovish, these probabilities will only rocket higher. As a result, EUR/USD and carry trades could continue to gain as long as the markets foresee a cut in rates in the near-term. Regardless of the FOMC’s actual decision, be prepared for some active trading on Wednesday.

Richard Lee is a Currency Strategist at FXCM.