GDP Annualized (3Q A) (12:30 GMT; 08:30 ET)
Expected: 3.1%
Previous: 3.8%

FOMC Rate Decision (18:15 GMT; 14:15 ET)
Expected: 4.50%
Previous: 4.75%

How Will the Markets React?

The gloomy US economic picture may only get worse on Wednesday morning, just ahead of the Federal Reserve’s highly anticipated rate decision, as Q3 GDP is expected to reflect a slowdown from Q2 to 3.1 percent. Though this is a relatively solid pace of growth, Q4 is highly unlikely to be so optimistic. Market reaction may be limited as the marquee event is the FOMC rate decision at 14:15 ET. Currently, Fed fund futures are pricing in a 94 percent chance of a 25 basis point cut to 4.50 percent and, 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 by cutting them by 50bp in a proactive attempt to prevent an all-out recession. How the forex, fixed income, and equity markets will react on Wednesday will be dependent not only upon the actual policy decision but also on how badly 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. Given all of the dovish potential surrounding the upcoming FOMC meeting, there may be more gains in store for Treasuries and US equities, while additional weakness may await the US dollar.

Bonds – 10-Year Treasury Note Futures

Treasuries have narrowed into a pennant formation on the daily charts, and with major event risk from the FOMC meeting, the contract is likely to break out. Ahead of the 14:15 ET announcement, trade will likely be light as Tresuries will consolidate further. However, if the FOMC cuts rates 25bp and signals a dovish bias or if they cut rates by 50bp, Treasuries will likely rocket up towards the highs at the 111-06 level. However, if the FOMC surprises the markets and leave rates unchanged, the contracts may break down to 110-04.

FX – EUR/USD

Market-wide weakness in the greenback has allowed EUR/USD to continue its ascent towards 1.4500, though the pair paused to consolidate recent gains near the 1.4400 level. The most recent COT report published by DailyFX Technical Strategist Jamie Saettele signals that neither the Euro or the US dollar trade at extreme levels anymore, allowing further upside potential for the EUR/USD pair. Nevertheless, traders should be extremely cautious given the extent of the event risk looming on Wednesday. The FOMC rate decision tends to be a highly market-moving event, but it is even more so this time given the uncertainty surrounding what they will actually do. Fed fund futures are pricing in a 94 percent chance of a 25bp cut to 4.50 percent, while there is a 6 percent chance that the central bank will leave rates unchanged. With credit conditions still tight and the housing sector steadily deteriorating, it appears that there is enough fundamental reason for the FOMC to cut rates. If this is the case and the central bank cut rates by 25bp and issues a dovish policy statement, or if the bank cuts them by 50bp in a proactive attempt to prevent an all out recession, there is little doubt EUR/USD will rocket up to the 1.4500 level.

However, with price pressures building vis-à-vis food and energy, there is speculation that a rate cut will only stoke inflation further. Moreover, Federal Reserve Governor Frederic Mishkin recently touted the discount rate as a “more targeted tool for coping with financial disturbances without promoting inflationary tendencies.” In order to only focus on the credit markets, there is a chance that the FOMC will only adjust the discount rate and will leave the federal funds rate unchanged. If this is the case, EUR/USD will likely pull back sharply towards 1.4320.

Equities – Dow Jones Industrial Average

The Dow pulled back from resistance at the 13,896 level ahead of major US event risk, as the FOMC is widely anticipated to cut rates by 25bp to 4.50 percent. Equity traders in particular are counting on a rate cut and will continue to rally until the Fed says “stop” and leaves rates unchanged. As a result, a rate cut in line with expectations will likely give the Dow at least a slight boost to push towards 14,000. If the policy statement is overtly dovish or if the FOMC surprises the markets with a 50bp cut, US equities may rally fiercely.

On the other hand, if the FOMC holds their ground and leaves rate unchanged, US equities will sell off significantly to target the 100 SMA at 13,571, though given how bearish this decision would be, this support level may not hold for long. Only a cut to the discount rate rather than the federal funds rate, though, could help cushion declines in the Dow to a certain degree.

Terri Belkas is a Currency Strategist at FXCM.