What Are The Markets Facing?

Heightened uncertainty surrounding the US Federal Open Market Committee’s interest rate decision at 14:15 EDT virtually guarantees volatility across almost all asset classes - making it the most important event to watch in the week ahead. Economists overwhelmingly expect the Federal Reserve to leave rates steady at 2.00 percent for the first time since August 2007, putting an end to the FOMC’s aggressive rate-cutting cycle. In fact, fed fund futures are actually pricing in a whopping 59 percent chance of a 25bp rate hike to 2.25 percent by September. Indeed, the markets expectations have shifted quite a bit on hawkish commentary by various FOMC members and indications of rapidly building inflation pressures. However, the US economy is still facing a major slowdown, if not an all-out recession. Furthermore, US Treasury Secretary Henry Paulson and FDIC Chairman Sheila Bair have recently called for clear procedures for shutting down failed investment banks, suggesting turmoil in the financial sector is bound to get worse. In the end, the hawkish tone of the FOMC may be intended purely to quell consumers’ inflation expectations (and lead the US dollar to appreciate), as the Federal Reserve has very little room for error and almost no room to raise interest rates.

Bonds – 10-Year Treasury Note Futures

Treasuries remain very heavy as the markets price in the potential for a rate hike by the Federal Reserve, but the contract has recently bounced from support at 112 on the back of weak US housing market and consumer confidence data. However, the FOMC rate decision presents substantial event risk for Treasuries. While the Fed is not expected to change rates, there is potential for the policy statement to focus heavily on inflation, which could lead the markets to be more aggressive in pricing in a September rate hike and push Treasuries back down toward the December low of 111-16.

FX – EUR/USD

EUR/USD continues to trade within a wide range of 1.5350 – 1.5800, as the US dollar consolidates ahead of the Federal Reserve’s rate decision on Wednesday. Looking ahead to Tuesday, the FOMC is widely expected to leave rates steady at 2.00 percent. However, if the FOMC’s policy statement indicates a pronounced focus on inflation rather than credit conditions, the financial markets, or the economy, the US dollar could actually rally as traders rush to price the potential for rate hike in September. In this case, EUR/USD could fall toward the recent lows at 1.5465 and the 100 SMA at 1.5440. On the other hand, if the FOMC changes course and brushes off inflation, the pair could spike above resistance at 1.5550/70 toward 1.5650.

Equities – Dow Jones Industrial Average

The Dow Jones Industrial Average tumbled to test the March lows at 11,731 on Tuesday, as the trend in the index is clearly bearish. Risks for the DJIA remain to the downside, especially since any indications of distress in the financial sector has the ability to trigger sharp sell-offs in the equity markets. Furthermore, upcoming US news could lead the DJIA down for a test of this zone as the FOMC is likely to leave rates steady on Wednesday, but issue hawkish commentary in their concurrent policy statement. As a result, the DJIA may test 11,731 once again, while sharp declines may lead the index to test the January lows at 11,634.

On the other hand, if the FOMC policy statement doesn’t give the markets much to work with, the DJIA may simply stabilize near Tuesday’s closing levels.

Terri Belkas is a Currency Strategist at FXCM.