Tomorrow (Wednesday Apr. 30) at 1415ET/1815GMT the FOMC will announce its interest rate decision and provide an update on their outlook for the economy and the future direction of monetary policy (the accompanying statement). Below are my expectations for the FOMC decision and the likely market reaction.

In just the last two weeks, the market has migrated from a roughly 50/50 split between 25 or 50 bps of easing to the view that the Fed will either 1) cut rates by only 25 bps from 2.25% to 2.00% (82% likelihood according to Fed Fund futures today) and indicate that easing to date should be sufficient to stabilize the economic outlook (the Pause), or 2)hold rates steady at 2.25% (18% probability according to FF futures) and indicate that easing to date should be sufficient to support the economy going forward (the Pause). The Fed will undoubtedly refer to inflation pressures as part of its justification for signaling a pause in additional rate cuts, but at the same time the statement is also likely to keep the door open to further easing should economic conditions warrant that.

However, I believe the most significant element of the FOMC statement will be the Fed's updated assessment of the economy and their outlook, both of which are very likely to have deteriorated further since the March 18 statement, given ongoing increases in energy and food prices, rising unemployment, falling home values, and restricted credit. In particular, be alert should the Fed explicitly alter its expectation for an improvement in the economy in the second half of 2008.

Over the past two weeks, markets have moved to "price-out" further Fed rate cuts and have begun to build in expectations for rate hikes as early as late 2008. US Treasury yields and the USD have both moved higher over this time period, and stocks have generally recovered as well on the basis that such a Fed shift suggests the downturn is likely to be mild and relatively brief. Should the Fed deliver the market's preferred scenario of "one more rate cut and then a pause," there should not be significant further price adjustments, as current rates largely reflect this outcome.

On the other hand, should the FOMC deliver a bleaker economic assessment and outlook, as I expect, there is significant scope for prices to re-adjust to the prospect of a deeper and more protracted US downturn necessitating further easing. Treasury yields would plunge across the curve, likely taking the USD sharply lower. US stocks are also likely to react negatively, even though they may be initially buoyed by the prospect of an ongoing Fed commitment to cut rates further if necessary.

I expect a relatively volatile reaction immediately following the Fed announcement with two likely phases of price action. The first phase would involve the market reaction to any rate cut and language signaling a pause in easing. If the Fed cuts 25 bps, the USD would first dip, but then rebound quickly if language indicating a pause is included. Should the Fed hold rates steady, the USD would most likely move directly higher, especially if Pause language is included. The second phase would be the reaction based on the economic assessment, which I expect to dominate at the end of the day. If the outlook is downgraded as I expect, any USD positive impact from a pause is likely to be short-lived as markets move to "price back in" expectations for additional easing amid a deeper US downturn.

To complicate matters further, the stock market reaction is likely to lead to uneven movements for the dollar against other currencies. Again, if the Fed's outlook is downgraded further, I would ultimately expect stocks to turn south on the weaker US outlook and this will tend to see heavier selling of JPY-crosses. USD/JPY is most likely to bear the brunt of any USD selling, while EUR/USD and other pairs (e.g. GBP/USD, AUD/USD, NZD/USD) would likely see any gains (from USD selling) pared and possibly reversed as JPY-cross selling overwhelms and dominates.

Readers should note that my outlook is largely at odds with broader market expectations for a relatively upbeat, end-of-easing, the worst-is-over type of FOMC statement. But because of that disparity, the reaction is likely to be more volatile than many expect, which itself will fuel additional volatility. If the FOMC outlook is downgraded, I will be looking to sell rallies in USD/JPY (30-80 points above pre-Fed announcement levels) and to buy dips in EUR/USD after similar USD gains. Also, I will be looking to sell JPY-crosses if US stocks turn lower on a weaker Fed economic outlook.

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