Dollar Checks Back in Anticipation of FOMC Decision

Talking Points:

• Dollar Checks Back in Anticipation of FOMC Decision
• British Pound Volatility but Noncommittal After Inflation Report
• Euro Traders Will React to Fed and then ECB

Dollar Checks Back in Anticipation of FOMC Decision

This week’s top event risk is upon us. The Federal Reserve’s monetary policy meeting carries deeper meaning than just a quick move from the US Dollar. Given the fundamental platform the market has been built upon over the past few years – low participation, excessive leverage and a dependency on low volatility conditions – the impact of this event could ripple throughout the financial system. Yet, for those looking for the quick market-based evaluation of how the central bank’s actions and forecasts are being interpreted by the trading ranks, there are three benchmarks to monitor through the event: the US Dollar, the S&P 500 and US Treasury yields.

Before we can appreciate the full influence this policy meeting can impose on the financial system through short-term volatility and more enduring trend developments, we first must understand why it is important. This is not a standard FOMC meeting. While the central bank will almost certainly ‘Taper’ (reduce its monthly QE3 purchases) for the second-to-last time, there is far more too this particular gathering. As this is one of the quarterly meetings, the policy group will also release its updated forecasts on employment, inflation and interest rates. We are also due a press conference from Chairwoman Janet Yellen. These are crucial to reconciling a growing disparity in speculators’ rate expectations and even the projections the central bank itself is trying to shape. While the Dollar has rallied an incredible 9 straight weeks – matching the longest series on records going back nearly 50 years – Fed Funds futures are still discounting the Fed’s last set of forecasts.

There is serious risk in having the market’s views deviate too far from the central bank’s. The longer and broader the divergence, the more dramatic the eventual reconciliation. We have seen individual FOMC members and Fed-sponsored research mention this concern. There has also been a considerable anxiety from both local (Fed officials) and global (OECD, BIS, other central banks) groups over excessive risk taking and little regard for cooling economic trends nor the eventual end of stimulus. If the Fed is truly concerned about this imbalance, they will try to make an effort to clarify without committing. Many believe that can come in removing ‘considerable time’ for rates, but it may run deeper.

British Pound Volatility but Noncommittal After Inflation Report

GBPUSD carved out a 150-pip range Tuesday. That’s a substantial oscillation given the trend for the pair through the preceding week and the focus on upcoming major event risk. However, volatility in the wake of UK inflation figures for August is not surprising. Rate forecasts for the BoE are a critical fundamental driver for the sterling both in the 12-month rally through July and the subsequent retracement over the past two months as markets backed off their convictions of a 2014 first hike. However, the 1.9 percent core CPI does little to increase the price pressures raises limited speculative ire when we have something as open-ended as the Scottish Referendum ahead of us. The vote’s potential ramifications are so broad that the market will be similarly cool to today’s BoE minutes and August jobs data.

Euro Traders Will React to Fed and then ECB

The ECB (European Central Bank) is scheduled to announce the take up of its first TLTRO (targeted, long-term refinancing operation) Thursday – the first upgrade in the group’s balance sheet in over two years. Given the aggressive decline for the Euro and Euro-area lending rates over the past months, the market clearly cares. Yet, is it allowing for much of a surprise from the event? Whether the appetite for the loans are light or heavy, they have a target for increasing the balance sheet back towards ‘beginning of 2012’ levels (€600 billion to €1 trillion higher from here) . Meanwhile, a change in Fed tack can leverage the pressure on the Eurozone to do more to calm its markets.

Yen Crosses: Be Careful of a Risk Response to Fed

Most traders will be staring at charts of the Dollar, US equities and perhaps even USDJPY as the FOMC event unfolds. However, the Yen crosses may be just as exposed – if not more – than those assets with closer geographic proximity. These pairs have advanced on an explicit assumption of global stimulus. The effectiveness of the BoJ’s efforts depend on the international effort being made. And, the appetite for carry is dependent on risk appetite which is extremely exposed to the one of the biggest stimulus providers reversing course.

Australian Dollar Rallies After PBOC Announces Fresh ‘Stimulus’

This past session didn’t open particularly well for the Australian dollar as Chinese direct investment numbers printed at a four-year high and suggested the country’s largest trade partner continued to cool. That concern turned though when it was reported that China’s five largest banks would receive 500 billion yuan in liquidity to bolster the system. This isn’t a large scale move, so its lasting impact is dubious.

Emerging Markets Rally Before the Fed?

Are Emerging Markets ignoring impending event risk? The MSCI ETF posted a strong 1.3 percent rally after its recent cascade on the largest volume jump in six weeks. In the FX world, most of the liquid EM currencies gained significant ground against the US Dollar. This is not likely a new trend rather just a position adjustment. Many EM central bankers have warned of the risks they face due to the Fed’s actions.

Gold Bulls Ready Should the Fed to its Dovish Rhetoric

Gold is down 3.1 percent on the week, and the precious metal has trended lower for more than two months. An outlook of rising interest rates and the reversal of stimulus programs (which bolsters the value of fiat currencies) have certainly sunk into the precious metal. Yet, if there is a delay from the Fed for a return to norm, gold traders would still likely take advantage with a short-term rally.

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--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

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