Most U.S. banks remain anxious about liquidity and nervous about counterparty credit risk. For example, DJ credit default swaps, a financial instrument whose price derives inversely from the creditworthiness of the obligations of a third party, remain far above the levels seen in the beginning of 2007. Moreover, the yield spread between low grade bonds and U.S. Treasuries remains uncomfortably high since investors remain worried about the deterioration of the U.S. economy.
According to Fed Funds interest rate futures, market expectations are clearly skewed for a rate cut. The implied probability shows that there is a 75 percent chance for a rate cut when the Fed meets on October 31st.
If the Federal Reserve cuts interest rates on October 31st by 25 bps, the lower borrowing costs should help the U.S. stock market but the lower yield on deposits based in U.S. dollars should drag the greenback to new lows against both the euro and sterling. The rate cut should have a limited impact on the Japanese yen since the USDJPY has been positively correlated with the U.S. stock market over the last two decades.