As global financial markets continue to roil, it has become painfully obvious that Federal Reserve Chairman Ben Bernanke has encountered the “first year curse.” Indeed, a marked liquidity crunch has sent volatility spiking, short-term Treasuries rallying, and has turned the US Dollar into a safe-haven asset. Under a significant amount of pressure, the Federal Reserve has a few options for trying to restore calm in the financial markets. However, what may be good for providing liquidity and stabilization may not necessarily be good for dollar bulls.

Has Greenspan Already Set The Stage For A Rate Cut By Bernanke?

The stakes are quite high for the Federal Reserve, as a continued liquidity crunch threatens to severely impair financial operations and economic growth. The Federal Reserve has taken many measures to try to stem some of these pressures, as they lent billions of dollars of temporary reserves to the banking system and also went so far as to cut its discount rate by 50 basis points to 5.75 percent on Friday in an attempt to help distressed banks borrow money. Nevertheless, Ben “Helicopter” Bernanke could be coming in with additional assistance for the markets.

For this we take a little history lesson: Nearly nine years ago, former Federal Reserve Chairman Alan Greenspan faced a similar financial crisis and after an earlier meeting with the rest of the FOMC in Jackson Hole, Wyoming, he called for an emergency conference call on September 21, 1998. Starting just eight days later on September 29, Greenspan and Co. cut interest rates by 25 basis points, and did so again at the next two policy meetings. Bernanke has already started to follow suit, as the previously mentioned 50 basis point cut to the discount rate was the result of a video conference last Thursday night. Furthermore, the US central bankers will gather at the end of this month in Jackson Hole, and at the time of writing, Fed funds futures show that traders are betting on at least a 25 basis point cut to 5.00 percent at the Federal Reserve’s next policy meeting on September 18, with the potential of a 50 basis point cut being priced in.

There is additional evidence that the Federal Reserve will make an effort to make monetary policy less restrictive. Some of the factors that the central bank will be watching to see if their prior policy actions have made an impact include: the bid-ask spread on high quality commercial paper, short-term treasury rates, and credit spreads. Thus far, these metrics are not very positive. Though commercial paper spreads have tightened over the past two days, they still remain historically wide as funds continue to flow towards “safe-haven” assets such as US Treasuries. Though the three-month Treasury bill fell slightly on Wednesday, leading yields to 3.92 percent, rates are still extremely low after they posted their sharpest decline since 1987 on Monday. Furthermore, the correction in the financial markets isn’t like to be over yet, as US Treasury Secretary Henry Paulson even noted on Tuesday that “this is going to take a while to play out.”

What About the US Dollar and Carry Trades?

One of the most surprising things we’ve seen throughout all of this is the price action in the forex markets, as the US Dollar has strengthened significantly against currencies like the Euro and British Pound, while carry trades have unraveled at a frightening pace. Indeed, since August 9th, EUR/USD has dropped over 3 percent from near 1.3800 to as low as 1.3359, while GBP/USD has plunged more than 3.5 percent from 2.0400 all the way down to 1.9649. While both of these pairs have made gains over the past few days, the greenback has clearly shown its power in the face of risk aversion. Though it seems counterintuitive for the US dollar to appreciate in the face of worsening financial and economic conditions, the currency has turned into a global safe-haven instrument. Furthermore, as traders pull funds out of foreign equity markets and buy up US assets, such as Treasuries, the subsequent flow of funds instantly creates demand for the US dollar and helps drive up its value.

One of the only currencies that the US dollar has fallen against is the oft-beleaguered Japanese yen, as USD/JPY descended over 6 percent from the 119.50 level to challenge 14-month lows near 112.00 amidst a massive unwinding of carry trades. Showing even more dramatic moves, pairs like EUR/JPY, which traded quietly at the 165.30 level on August 8th, found itself down almost 10 percent by August 17th. This price action was representative of the warnings that global central bank officials have given for months, as they suggested that such “one way bets” could crash quickly. The surge in volatility experienced indeed took the steam out of such carry trades, as highly leveraged positions tend to only prosper during quieter times for the markets.

Going forward, the potential for policy action by the Federal Reserve would seem likely to make the US dollar less attractive amidst lower interest rates and slower growth prospects. However, if financial markets appear dour enough to force the Federal Reserve to cut rates, other central banks may be forced into the same position. For example, both the European Central Bank and the Bank of England were expected to hike their overnight lending rates before year end, but given the tight liquidity conditions and the downside risks that they present to the economy, these estimates have been scaled back dramatically.

Meanwhile, the status of the once-lucrative carry trade will remain contingent upon the status of equity markets, which has served as an excellent barometer of the risk-seeking nature of forex traders. As a result, if policy action by the Federal Reserve fails to leave Wall Street satisfied and confident that equity indexes, like the Dow Jones Industrial Average, will resume their previously strong rallies, the profitability of carry trades could continue to wane.

What the Fed Do Over the Next Few Months:

1 Rate Cut in September, 1 Rate Cut in October

A 25 basis point cut on or before the September 18th meeting followed by another rate cut before Christmas is very much priced into interest rate futures and has been ever since August 9th, when the liquidity crunch initially hit bond and equity markets. In fact, just a day prior, the markets were pricing in only a 20 percent probability of a September cut and 100 percent chance of only one 25bp reduction by the end of the year. This slower approach to loosening monetary conditions may be preferred by the Federal Reserve, as Bernanke will likely want to allow time to gauge the impact of their previous policy actions. Furthermore, the US dollar, carry trades, and equity markets may be more even-keeled in coming months as a less extreme policy move in the near-term would create the potential for additional policy action in the long-term. Nevertheless, traders should count on a spike in volatility on the announcement of any policy decision.

50bp Cut in September

As we mentioned above, a 25 basis point interest-rate cut is already priced in for September, but what about a more dramatic cut? At the time of writing, futures show that traders see a 54 percent chance of a half-point cut to 4.75 percent, down from 90 percent on Tuesday but up from zero percent a week ago. If the markets continue to experience major volatility and equity markets start to get pummeled once again, the probabilities of such a move will only increase. Over the next few months, a 50 basis point cut may prove to be the most bullish for equity markets, who will breathe a sigh of relief, but bearish for the US dollar as interest rate differentials would be quickly out of favor for the currency.

No Rate Cut in September, 1 Rate Cut in October

At the moment, a decision by the Federal Reserve to leave rates unchanged in September appears to be the most unlikely scenario. While we have seen equity and bond markets start to calm down, Wall Street still appears to be anxious for some sort of policy action by the Federal Reserve in the near-term, and at this juncture, one of the central bank’s main goals is to prevent a panic, which could occur if the markets don’t believe that they will receive any assistance. However, this could also be the most bullish for the US dollar and bearish for carry trades, as risk aversion would rocket higher once again.

Terri Belkas is a Currency Strategist at FXCM.