Fed Preview: The currencies to trade in each of these four scenarios

The Federal Reserve is most likely to cut its interest rate by 25 basis points. The bank has been preparing markets for such a move since June. There are two main reasons for the first rate reduction since the crisis.

Background – Clouds are darkening

The first is weak inflation. The Fed has changed its stance that weak price development in the first quarter was only "transitory" and is now concerned about reaching its 2% target. The second reason is global trade tensions, which dim the outlook. 

Markets have been pricing in a series of rate cuts beginning from this meeting, while some Fed officials have been far more cautious. James Bullard, President of the Saint Louis branch of the Federal Reserve has stressed that he sees July's cut as an "insurance" move – a one-off reduction and nothing else. Bullard is known as a dove that rejected the last rate hike in December, and his words poured cold water on expectations. Moreover, recent data has been satisfactory, and trade talks have resumed – raising the chances for a "one and done" move – at least for now.

Despite falling expectations, markets still expect the Fed to reduce the Federal Funds Rate twice this year and twice again next year. Some analysts even see the Fed slashing rates by no less than 50 basis points this time.

Here are four scenarios for the Fed decision and the USD reaction:

1) Insurance cut – USD up

If Fed Chair Jerome Powell and the statement both convey a message that the bank is only pulling out its insurance and that they are unwilling to commit to any further moves – the greenback is set to rise.

This scenario has the highest probability given the recent economic data. The option is only partially priced in.

The greenback will likely gain across the board with notable rises against the euro, which is vulnerable after the ECB opened the door to a new stimulus. The pound may also struggle amid Brexit uncertainty. However, the yen may only suffer minor falls as a potential drop in stocks may limit any USD/JPY upside – equities and this currency pair are well-correlated. 

2) Cut and open door – USD down

The Fed may open the door to further rate cuts – adhering to market expectations – while not committing to any specific amount. Powell may stress rising uncertainties and refrain from ruling out more moves this year. 

In this scenario, which has medium probability, the US dollar would drop, but probably not plunge. After all, markets do expect further cuts.

The slide of the dollar may be uniform across the board as the Fed will only be catching up with its peers. The rise of USD/JPY depends on stocks, while the euro may be unable to make substantial gains as the ECB is set to act soon.

3) 50bp cut – USD crashes

To calm markets, Powell may opt for a shock cut of 50 basis points. Even if he says that no further moves are on the cards, a significant slash of rates will likely have a profound adverse impact on the greenback and will send stocks surging.

This scenario has low probability as the Washington-based institution will not want to be seen as succumbing to political pressure from across town – the White House. President Donald Trump's persistent pressure on the Fed may backfire as the bank fights to keep its independence.

In this scenario, commodity currencies such as the Canadian and Australian dollars may emerge as the overwhelming winners due to risk appetite that may sweep stock markets. The safe-haven yen could be the laggard in this case.

4( No cut – USD surges

Another low-probability scenario is that the recent upbeat data causes the Fed to hold their fire and only keep an open door to cutting rates in September – alongside new forecasts. In this scenario, the dollar would leap to higher ground, and stocks would crash.

The chances are extremely slim as it would contradict the bank's clear message to markets, but it cannot be ruled out.

Commodity currencies may suffer a massive sell-off alongside share prices with the euro and the pound trying to compete with them in the race to the bottom. The yen and perhaps the Swiss franc – a second-tier safe-haven – may outperform the US dollar and stand out in this unlikely development.

Conclusion

The Fed is set to cut rates and trigger high volatility, but the details of the event matter. Each currency may react in a different manner depending on the outcome. Stay tuned for live coverage of the all-important decision.