Fed fund futures continue to price in a 92 percent chance of a 25bp rate cut on Wednesday to 4.50 percent. With FOMC member Mishkin noting that the markets have not fully normalized yet, it appears that the central bank will indeed loosen monetary policy. The question is: how will they go about it? Will they cut the federal funds rate and the discount rate like they did in September, or will they try to target the credit crunch by only easing the discount rate? The latter option may be able to give the US dollar a long awaited bid tone while allowing the equity markets to deflate slowly rather than crashing. Regardless, the Federal Reserve’s policy decision on October 31st promises to spark some wild price action market-wide.

Yield Spread Analysis 10/23 – 10/30

Over the course of the past week, yield curve movements have been fairly minimal though government bonds generally gave up gains from the week prior as traders became more risk-seeking. In Canada, short-term yields fell 14bp amidst concerns that the rapid appreciation of the Canadian dollar would impair exports – the lynchpin of growth in Canada – and subsequently lead the Bank of Canada to consider cutting rates. In Australia, short-term yields did the exact opposite and rocketed 12bp higher as stronger-than-expected CPI has led the markets to price in a November rate hike by the Reserve Bank of Australia. Meanwhile, a slightly hawkish policy statement from the Reserve Bank of New Zealand sent the both the short and long ends of the curve higher – though the 10-year bonds benefited most – as the central bank shows few signs of cutting rates anytime soon.

The major event risk this week lies in the FOMC rate decision, as fed fund futures are pricing in a 92 percent chance of a 25bp cut, but there is potential for the central bank to make a surprising announcement. Regardless of the decision, price action in the fixed income, forex, and equity markets will be wild on Wednesday and traders should pay heed.

US Fed: Highly Anticipated 25bp Rate Cut Promises Wild Price Action

Fed fund futures continue to price in a 92 percent chance of a 25bp rate cut on Wednesday to 4.50 percent. With FOMC member Mishkin noting that the markets have not fully normalized yet, it appears that the central bank will indeed loosen monetary policy. The question is: how will they go about it? Will they cut the federal funds rate and the discount rate like they did in September, or will they try to target the credit crunch by only easing the discount rate? The latter option may be able to give the US dollar a long awaited bid tone while allowing the equity markets to deflate slowly rather than crashing. Regardless, the Federal Reserve’s policy decision on October 31st promises to spark some wild price action market-wide:

Frederic Mishkin, Federal Reserve Board Governor (Voting Member)

“Since the Federal Reserve cut interest rates and added liquidity to the financial markets, functioning has not yet returned to normal.” – October 29, 2007

“…lowering the discount rate may also help underscore the central bank's intent to provide adequate liquidity to promote the functioning of financial markets…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.” – October 26, 2007

There is little doubt the housing market is still an issue, which will likely be noted in the FOMC policy statement:

Randall Kroszner, Federal Reserve Governor (Voting Member)

“We share the concerns of Congress that certain lending practices may have led to the problems we are seeing in the sub-prime market today.” – October 24, 2007

Henry Paulson, US Treasury Secretary

“I believe there is enough strength in our economy that we will continue to grow through this, housing is the weakest part of the economy.” – October 30, 2007

“All of those markets are doing better every day, as time goes on compared to where they were a number of weeks ago, but it is going to take a while to work our way through…Six months ago, a year ago, people were more optimistic that we had hit bottom. We haven't hit bottom yet in the housing area.” – October 30, 2007

Alan Greenspan, Former Federal Reserve Chairman

“Where the problem lies is in home prices -- new home prices, very specifically. The question is not so much the housing market per se, but it's the effect of housing on the economy overall.” – October 24, 2007

BOJ: Stubborn Deflation To Keep Rates On Hold

Bank of Japan monetary policy committee members have been notably absent from the press before the upcoming rate decision. Despite the fact that the economy remains in deflation and consumption trends have proven to be relatively lifeless, there are still hawks, such as Miyako Suda, Atsushi Mizuno and Tadao Noda, waiting in the wings. Nevertheless, government officials – who are widely perceived as being staunchly against rate normalization – continue to make their presence known and will likely publicly applaud the Bank of Japan’s expected decision to leave rates steady at 0.50 percent on Tuesday night:

Fukushiro Nukaga, Japanese Finance Minister

“(Core consumer) prices are moving near zero, basically, but it is desirable for prices to stabilize in order (for people) to feel the economy's recovery.” – October 26, 2007

“Deflationary conditions haven't been completely overcome, but we are in the process of overcoming them…overall, prices are around zero and flat.” – October 30, 2007

Hiroko Ota, Japanese Economics Minister

“Conditions regarding prices haven't really changed these days. But I think prices will eventually rise, reflecting the recent tighter demand-supply situation.” – October 26, 2007

“The improvement in the job market has slowed slightly, but production is picking up. We don't need to worry about (the jobs data) that much.” – October 30, 2007

Nobuo Inaba, Bank of Japan Executive Director

“In guiding monetary policy, we need to carefully consider the effects, side effects and risks of our decisions. As a favorable mechanism in production, income and spending remains intact, we can expect the Japanese economy to achieve sustained growth under price stability.” – October 30, 2007

Richard Lee is a Currency Strategist at FXCM.