Federal Reserve interest rate announcements have traditionally been big market movers for the US dollar, but with a major liquidity crunch taking a heavy toll on the financial sector as a whole, equity traders may be watching the news most closely of all. There is no doubt the Fed will cut rates on Tuesday, as the collapse of the financial markets along with a marked deterioration in economic conditions warrants aggressive action by the central bank. Futures markets are pricing in another 150bps worth of rate cuts by June, and of that, we are expecting a 100bp reduction this week.

Indeed, as it becomes obvious that the Fed’s typical policy tools have been rather ineffective, they’ve been forced to become a bit more creative and create various lending facilities in order to keep the markets functioning. The most recent initiative represents the largest expansion of their lending authority since the 1930’s and will allow the Fed to lend to primary dealers (non-bank financial institutions), such as Goldman Sachs, on many of the same terms as banks. Furthermore, the Fed reduced the discount rate by 25bps to 3.25 percent and extended the terms of such loans to 90 days from 30 days.

The mere harkening of the Depression-era has the markets spooked, and with banks still extremely wary to lend, the Fed’s most recent actions are unlikely to do the trick. Additionally, the downside risks to growth have risen substantially, further supporting the case for more accommodative monetary policy.

US Economic Data: How Have Things Changed Since the Last Meeting?

The majority of US indicators reflect major weakness in the US economy. As consumer sentiment has waned amidst rocketing energy costs and crumbling equity markets, spending has taken a sharp hit with retail sales sliding 0.6 percent in February. Indeed, the non-manufacturing sector in general – which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance – is looking rocky as the February ISM survey remained in contractionary territory, despite a mild improvement. Likewise, the manufacturing sector isn’t faring well as the depreciation of the US dollar has done little to boost export demand. Producers are also grappling with high raw material costs that they are unable to pass on to their buyers, and as a result, profit margins are narrowing. Labor market trends do not bode well for growth either, as non-farm payrolls have fallen negative for two consecutive months. With finance-related companies, among many others, likely to shed even more workers as the market turmoil worsens, employment conditions may continue to sour as well.

What about the housing sector? Pending, new, and existing home sales are still showing declining purchases as supply far outweighs demand; not to mention that restrictive borrowing requirements make it difficult for even the most credit-worthy to get a mortgage. It appears that the only encouraging development for the Federal Open Market Committee is inflation: both headline and core CPI growth slowed in February despite the massive gains in energy and good prices. Overall, nearly every economic indicator we follow points to additional rate cuts by the Fed on Tuesday.

On Average, Economists Are Expecting a 75bp Cut

According to a Bloomberg News poll, the median of a survey of 101 economists reflects expectations for the FOMC to cut rates by 75bps. Indeed, futures had been pricing in either a 50bp or 75bp reduction since the last policy meeting, and under normal circumstances, we would also expect a more moderate reaction from the Fed given substantial upside inflation risks. If Bernanke & Co. do indeed decide to take this course of action, US dollar bulls may have a reason to come back into the forex markets. Nevertheless, traders should count on a spike in volatility on the announcement of any policy decision. Furthermore, as long as the Fed is expected to cut rates again, weakness in the US dollar may be sustained.

We Follow the Futures Markets and Expect a 100bp Reduction

As we mentioned above, under normal circumstances we might expect the Fed to react in a more temperate manner, but it’s painfully clear that we are not in the midst of a typical scenario. As a result, we anticipate that the central bank will continue to follow what the markets dictate, as fed fund futures are fully pricing in a 100bp cut. Indeed, the markets started leaning towards such a move in early March, following the disappointing non-farm payroll numbers that showed a net loss of 63,000 workers in February (against expectations of a 23,000 worker gain). A 100bp decrease in the fed funds rate would be the sharpest cut since October 1984, when the central bank slashed rates by 175bp in one fell swoop. Given the extent of the current liquidity crunch and the contagion risks associated with it, Bernanke and his fellow committee members will be looking to alleviate some of the stress in the markets. The policy action would be a bullish move for the equity markets and a bearish result for the greenback, and could result in another record high for the EUR/USD pair above the 1.5900 level.

Will They Enact A Drastic 125bp Cut?

At the time of writing, fed fund futures are pricing in a 16 percent chance of a drastic 125bp cut to three-and-a-half year low of 1.75 percent. There’s no doubt that aggressive monetary policy action is warranted, but if the Fed starts embarking on such severe reductions, they will leave themselves little room for maneuver in coming months. Furthermore, the news would be disastrous for the US dollar, which continues to trade near record lows. While EUR/USD has backed down from the all-time high of 1.5900 established on Sunday, the pair’s rally could resume rather rapidly to take on this level once again, with a break above targeting the psychologically important 1.60 mark. However, in the case that another round of negative financial sector news – such as the reports we’ve seen regarding Bear Stearns – EUR/USD may not hesitate to punch above 1.60 to hit 1.65, as investors would likely continue to flee in droves away from the US dollar into currencies like the Japanese yen and Swiss franc.

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, the status of the financial markets took center stage and this is likely to remain the case. Additionally, economic conditions have deteriorated quite a bit since January, and Team Bernanke will not be able to ignore this. As a result, a pronounced focus on these factors would increase the risks of continued weakness in the greenback. However, the FOMC could suggest that the combination of past rate cuts and creation of new lending facilities may be enough to stabilize the markets in the near-term. Furthermore, the easing in inflation pressures will be considered very good news to the central bank, and if the FOMC takes note of this as well, the news may override any reaction to the actual rate cuts to become the most bullish case for the greenback.

Terri Belkas is a Currency Strategist at FXCM.