US Dollar, Fed Rate Hike Expectations Hinge on FOMC Statement

[B]AUG 7 FOMC Rate Decision (14:15 EST; 18:15 GMT)
Expected: 5.25%
Previous: 5.25%[/B]

[B]How Will The Markets React?[/B]
There is little doubt that the Federal Open Market Committee will leave rates steady at 5.25 percent on Tuesday at 14:15 EST, as Federal Reserve Chairman Ben Bernanke told Congress in mid-July that the central bank is not convinced that the improvements made in lowering inflation can be maintained. However, traders will still anxiously await the concurrent release of the Fed?s policy statement, as massive turbulence throughout the financial markets could lead to some re-wording, and these semantics tend to be highly market moving. Focus on the statement will first move to the Fed?s inflation stance and whether the bank still views it as their “predominant concern,” as anything less will be considered to be dovish. Meanwhile, the Fed will also have a chance to pay heed to the surge in risk aversion and credit spreads, along with the subsequent plunge in the equity markets. If this is accompanied by downgrades to growth forecasts, markets may start to believe that the Fed is mulling over a rate cut in the future, especially as the November fed funds contract shows a 100 percent chance of a 25bp cut to 5 percent by its October 31st meeting. On the other hand, if the Fed notes the recent plunge in equities and rally in Treasuries, but brushes off their impact, fixed income, forex, and stock market traders may do the same.
[B]Bonds - 10-Year Treasury Note Futures[/B]
Intraday charts showed the 10-year Treasury note futures gapped higher on Monday?s open and then slipped into the close, leaving a bearish candlestick pattern that may signal that the market may have seen a near-term top. A close tomorrow below the daily swing point support at 107-21 will provide bearish confirmation, and the move could be sparked by the FOMC policy statement, as consistent concerns regarding inflation could lead traders to believe that the chance of a rate cut by the Fed are being overestimated. On the other hand, a move to a noticeably less hawkish bias could push contracts to test 108-00 once again, with bullish sights set on 108-16.
[B]10-Year Treasury Note Futures (Daily Chart)[/B]

EUR/USD made a run for the July 24th high of 1.3851 on Monday following a bout of widespread dollar weakness on Friday, which was perpetuated by worse-than-expected labor market and services sector data. However, the release of the FOMC?s policy statement on Tuesday could prove to be an even bigger market mover, as any phrase changes could lead traders to ramp up speculation of a rate cut in the near-term. Forex traders will be most concerned with references to inflation, especially if the Fed deletes the line noting that “the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected” and replaces it with more neutral or dovish commentary. As a result of such a shift, the US dollar could plummet and push EUR/USD to retest the record highs, and perhaps even make a break for 1.3900. However, EUR/USD remains vastly oversold and gains could be short-lived. On the flip side, if the Fed continues to cite inflation risks and brushes off recent turbulence in the financial markets, the greenback could rally and send EUR/USD towards 1.3608, as fed fund futures are likely overestimating the probability of a rate cut by the central bank this year.
[B]EUR/USD (Daily Chart)

[B]Equities - S&P 500 Index[/B]
On Monday, the S&P 500 recovered most of Friday?s losses as a broad rally in US equities prevailed for much of the day. However, substantial event risk looms for the S&P 500 as the FOMC rate decision will be announced on Tuesday, along with the release of a policy statement. With the Fed widely expected to leave rates steady, it will be the statement that will garner the most attention and equity traders will be looking to gauge whether the central bank drops its inflation bias. If the FOMC maintains that inflation remains the bank?s predominant concern, US equities could turn lower as the Fed will be more likely to leave rates on hold. On the other hand, a more neutral or dovish tone may help push the S&P up towards the 1,500 level once again.
[B]S&P 500 Index (Daily Chart)