It’s Fed Week!

Last week witnessed a well-coordinated rally in global financial markets that propelled U.S. stocks more than 2% higher as investors around the world waited for the Fed’s response to the global credit crunch.

Of course the high-profile event of this week will undoubtedly be tomorrow’s FOMC meeting when the Fed is widely expected to cut interest rates in the face of mounting evidence of a U.S. economic slowdown.

According to Bloomberg news “Interest-rate futures show traders see a 58 percent chance of a half-percentage-point cut in the Fed's target for the overnight lending rate”; that probability has increased sharply from virtually ZERO chance of a hefty half-point cut just one month ago.

Will this Be Just the First of Many Cuts?

Still, the Fed’s most likely course of action would be a “measured” quarter-point cut in fed funds to 5%, followed by a more intense “monitoring of incoming data” on the economy before it moves to ease rates by another quarter-point in the near future.

Whatever the actual policy action, it’s worth remembering that the Fed has historically moved interest rates up and down in broad cycles – meaning that even just a quarter-point rate cut tomorrow is likely to be only the first of several similar moves.

The last time the Fed made a rate move – any move – was June 2006 when it hiked fed funds a quarter-point to 5.25%, in the last of seventeen-straight rate increases over a two-year period that began with a benchmark rate of just 1% back in June 2004.

However, the Fed finds itself between a rock and a hard place when it comes to interest rate easing, whether “measured” or not. In point of fact the Fed is caught between a plunging dollar on the one hand and the possibility of recession on the other.

Falling interest rates may help prop up the economy, but should put the dollar under even more intense selling pressure.

Defending the Dollar... Rate Cuts Sure Won’t Help

Last week, the greenback fell within a penny of its record low against the euro, and notched a fresh 30 year low against the Canadian dollar. And the ongoing yen carry-trade unwind led to the biggest dollar decline against Japan’s currency in more than a week.

If we are in store for a “slow and steady easing cycle in the U.S.”, according to one analyst quoted by Bloomberg, and “interest-rate differentials return to drive currencies and the Fed is likely to ease relatively to other countries, there's a lot of capacity for dollar selling from institutional investors.”

It should be an interesting week... oh and Wall Street’s major brokerage firms including the much beleaguered Bear Stearns are set to report their latest quarterly financial results this week too... warts and all! Look for more on the profit outlook for brokers in tomorrow’s blog.