FOMC Rate Decision (19:15 GMT; 14:15 EST)
Expected: -25bp to 4.25%
Previous: -25bp to 4.50%

What Are The Markets Facing?

The highly anticipated FOMC rate decision will come this Tuesday at 14:15 EST. Currently, Fed fund futures are pricing in a 68 percent chance of a 25 basis point cut to 4.25 percent, but equity traders been increasingly betting that the central bank will cut them by 50bp in an attempt to prevent an all out recession. Nevertheless, of the 119 economists polled by Bloomberg News, 80 percent expect a 25bp cut, 16 percent expect no change, and a mere 4 percent anticipate a 50bp cut. How the forex, fixed income, and equity markets will react on Tuesday afternoon will be dependent not only upon the actual policy decision but also on how badly the Federal Reserve judges the “strains on the financial markets” to be and whether they believe that “the upside risks to inflation roughly balance the downside risks to growth.” Headline consumer and producer prices were both up in the month of October and based upon increases in energy and food prices, the Federal Reserve is not likely to want to loosen their leash on inflation. However, some FOMC members have become more worried about the deterioration of economic growth in Q4 and the severity of the credit crunch, and as a result, 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 run into support at the 38 percent retracement of the latest rally and an ascending trendline near 112.14. The contracts could stand to gain ahead of Tuesday's FOMC meeting, as the central bank is expected to cut rates. Immediate resistance is at 112-25, followed by 113-11. On the other hand, if the FOMC’s policy statement signals that the bank may not cut rates again in January, Treasuries could actually be weighed down by the end of the day.

FX – EUR/USD

EUR/USD has continued its rally since running into trendline support at 1.4525, as traders look ahead to the FOMC meeting on Tuesday. The meeting is widely expected to yield at least a 25bp cut to the federal funds rate, if not a 50bp cut. Any rate cut will serve to weaken the greenback at first, but the currency could rebound later if the policy statement suggests that a rate cut is not in store next month. However, traders should also consider the outside possibility that the FOMC may not cut the federal funds rate at all and will only decrease the discount rate. While the chances of this are small, the impact the decision would have on the dollar is significant as the markets consider a 25bp cut a sure thing. Resistance looms above near 1.4870, which could mark a turning point for any additional EUR/USD gains. Meanwhile, support sits below at 1.4600, with sharp declines (that could result from an unexpected rate decision) targeting trendline support near 1.4550.

Equities – Dow Jones Industrial Average

The Dow’s rally may have been stopped short, or could be coming close to an end, as immediate resistance looms at 13,635 and additional resistance lies at 13,850. Indeed, expectations of a rate cut by the FOMC on Tuesday have fueled gains in the US equity markets, but where they go thereafter depends not only on the policy decision, but also the policy statement. A 25bp cut would support the Dow temporarily, while a 50bp cut could serve to fuel sharp gains for the index. However, how long those gains last depends on how severe the FOMC judges the strains in the financial market to be. Furthermore, whether equity market bulls stay in the game may depend on if the FOMC suggests that they will not cut rates again in January by noting that upside inflation risks outweigh downside risks to growth. The worst case scenario for the Dow is if the FOMC leaves the federal funds rate unchanged, as the markets essentially consider a 25bp cut a sure thing. Such a decision could allow the Dow to plummet back down towards 13,000.

Terri Belkas is a Currency Strategist at FXCM.