It’s the age old catch-22 for the Fed. Everyone and their mother is begging the Fed to lower rates. Let’s run through the scenarios.

If the Fed lowers the rate from 5.25% to 5% then “easy” money starts flowing again and the speculative bubbles re-emerge but that’s not the worst part. The US Dollar would fall even lower than it has and this wouldn’t bode well for our foreign investor friends who currently finance the war in Iraq, the bridge repair work, and everything else we buy. Our foreign investors would also hope that US Treasuries don’t become completely worthless. But the cherry on top of this sour cake would be runaway inflation as the market is flooded with more money at lower rates which drive up the costs of goods. I wonder if people would assume that if the rate is lowered then the Fed thinks we are headed into a recession, people panic and the market sells off.

If the Fed raises rates from 5.25% to 5.5% to stabilize the USD, attract more foreign investments, and fight inflation then the US Stock market begins a slippery slide downward as “safer” investments in bank instruments become much more appetizing than “risky” stocks. Of course, this would mean that those people struggling with their mortgage ARMS are in much deeper trouble now and this could in turn send more panic on all that CDO and ABS paper floating around. Panic would lead to a market sell off.

Quite honestly, I’m not sure how we will get through September or October without a market sell off which is why I’m in cash right now sitting it out. I’ve sat quietly for a few hours running through all the permutations in my head and I can’t see a way to fix this without some serious hurt on the markets. This could explain the anomaly on calls & puts on SPY.

I am considering shorting the market with some of my favorite ETFs such as SDS, DOG, or DXD but the large fluctuations in the currency market might be a better play as FXY might rally a bit if the BoJ raises rates in September -everyone’s expecting it but who knows what September will bring.