The US dollar has experienced a wild day of trading as the bankruptcy of Lehman Brothers has led the markets to price in a possible 25 basis point cut by the Federal Reserve on Tuesday. Will they reduce rates and more importantly, how will the meeting impact the US dollar this week?

How Will the Lehman Failure Impact the Federal Reserve’s Rate Decision?

When we first discussed the outlook for the Federal Reserve’s next meeting on September 16 in 5 Key Events for the Forex Market This Week, the scenario seemed fairly simple: slowing US growth along with indications of easing price pressures would diminish the Fed’s hawkish bias but still lead them to leave rates unchanged at 2.00%. However, a massive financial market shake-up has rattled interest rate expectations, as fed fund futures are now pricing in a 64% chance of a 25bp cut to 1.75% on Tuesday.

Last week, Merrill Lynch saw their shares get pummeled in the markets, and on Sunday, the firm sold itself to Bank of America for $50 billion, approximately half its peak value in early 2007. Lehman Brothers Holdings, on the other hand, was not so lucky: the firm filed the largest bankruptcy claim on record on Monday morning. The failure led stock markets to tumble around the world, including the Dow Jones Industrial Average, which plunged approximately 300 points at the NY open. Indeed, the Federal Reserve and US Treasury have helped to eliminate some of the moral hazard stemming from their intervention in Bear Stearns, Fannie Mae, and Freddie Mac, as they have essentially deemed Lehman as being not "too big to fail."

However, Lehman’s failure will impact other banks as well, since the firm had $613 billion in outstanding debts. According to Lehman's bankruptcy filing, the bank to take the biggest hit is AOZORA of Tokyo, as they loaned Lehman $463 million while Mizuho Corporate Bank Ltd. of Tokyo loaned $289 million. US banks are not in the clear either as Citibank loaned $275 million, serving as a blow to the already financially unstable bank.

The US Dollar Has Rallied Significantly, but the US Federal Reserve Could Spark a Reversal

The US dollar has rallied against the world’s most heavily traded currencies since mid-July on speculation the US Federal Reserve could open the door for a series of rate hikes in the months ahead. Indeed, the US dollar has gained the most versus high-yielders like the Australian dollar (+11.95%) and New Zealand dollar (+9.38%), while also rising versus the Euro (+8.22%) and British pound (+8.34%).

In recent days, though, the greenback has fallen sharply with interest rate expectations. In fact, Credit Suisse overnight index swaps – which had priced in over 50bps worth of hikes during the next 12 months just a week ago - are now actually starting to price in neutral policy going forward. As a result, the key to trading the US dollar this week will be not only the Federal Reserve’s rate decision, but also their policy statement. Our view? The FOMC will most likely leave rates at 2.00%, note significant downside risks to growth stemming from the housing market and financial instability, and could even note easing price pressures signaled by the drop in oil below $100/bbl along with the decrease in the US import and producer price indexes for the month of August. Thus, there is quite a bit of bearish potential for the US dollar this week.

Antonio Sousa is a Currency Analyst for FXCM.