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Why The Fed Is Stuck

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The subprime crisis and credit market troubles have effectively brought the abundant liquidity in the capital markets to an abrupt halt.

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All eyes are on the Fed today as the recent market weakness and increase in volatility has prompted investors to look to the Fed for help.

The subprime crisis and credit market troubles have effectively brought the abundant liquidity in the capital markets to an abrupt halt. While the Fed had previously been concerned about "the risk that inflation will fail to moderate", it now seems it could have a bigger problem on its hands. The subprime crisis has put the horrible domestic housing market conditions on the front burner, and this has put the Fed in the tight spot of having to move towards a more neutral bias.

Yesterday, odds for a rate cut by October 31 jumped to 100%, and 60% for two rate cuts by year end! I guess this is telegraphing the Fed will be a little less worried about inflation, and more concerned with the domestic credit issues that will trump other policy concerns.

However, it is going to be very hard for the Fed to "accommodate" the market by lowering rates. Looking at the chart of the dollar index below, you can clearly see it is on the verge of a massive breakdown.

A Fed cut could have disastrous results in the currency markets as lower rates would be a huge negative for the U.S. Dollar. Maybe a change in language to a more neutral stance will give the market some time to digest this unpleasant possibility of an even weaker dollar, but it just proves how the Fed is in such a tough spot.

A surprise cut could lead to a sharp currency move, which typically results in more market turmoil. The housing market and recent credit troubles won't get any better with constant or higher interest rates. Talk about being stuck between "a rock and a hard place". The Fed is right there and unfortunately the hard thing to do might be lowering rates because of the domestic troubles trumping what the markets would surely view as an admission that conditions are not "goldilocks" right now.

See the below chart of the dollar index. A sharp break below 80 could make current market volatility seem minimal.


Click here to enlarge.
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