Dollar to See a Breakout Regardless of FOMC Outcome
Heading into this week’s top event risk, the Dow Jones FXCM Dollar Index has worked itself into a position that necessitates a breakout. That looks like a perfect marriage of build up and catalyst from the FOMC rate decision. Yet, despite its technical predicament and the ominous approach of a key catalyst, clearing this congestion does not necessarily mean there is a new trend in store for the benchmark currency. Engaging risk aversion after years of leveraged investment into record high asset prices is difficult to muster. However, all the elements are there to feed the fire should the initial spark catch.
Much of the fundamental debate surrounding the topic of over-stretched risk trends and whether they are destined to correct has centered on valuations. Growth, yields, earnings and other traditional measures offer a worrying backdrop all on their own; but the circumstances surrounding the market’s performance beyond the ‘equilibrium point’ of capital returning after the Great Financial Crisis ended – arguably reached years ago – is where the true risk lies. Stimulus has reduced investors’ fear of market volatility while simultaneously reducing yield. In turn, this has curbed participation, amplified the use of leverage to record levels and forced investors into risky assets they traditionally wouldn’t even consider in order to make returns that exceed the S&P 500. That is not a durable foundation.
Against this backdrop, the world’s most prominent risk underwriter – the Federal Reserve – is starting to de-escalate its stimulus program. The central bank made its first move to ‘Taper’ its $85 Billion-per-month QE3 stimulus program at the last meeting on December 18. That decision was met with a mute response from both dollar and ‘risk-sensitive’ benchmarks. The restrained reaction was in part a function of the year-end trading conditions as well as market preparation. As the Fed further reduces its safety net and exposes investors to volatility riskthough, the passive sentiment will start to crack. A further $10 Billion Taper (to a $65 Bln pace) is the leading consensus – a belief well-supported by officials’ efforts to set expectations in the weeks following the December meet. A curb on the balance sheet growth for the Fed is a positive for the dollar in the ‘competitive monetary policy game’ and via yield forecasts. But, the scale of this event truly rests with the possibility that this regime is perceptible enough that it changes the masses’ view of risk-reward at these heights.
British Pound Mixed after ‘In-Line’ 4Q GDP Reading
Sterling bulls have been seeking out data that would validate their bullish views of for interest rate forecasts. The stronger the sterling has grown over these past six months though, the more difficult it is to impress. The 4Q UK GDP figures released this past session are robust in general. The 0.7 percent growth in the final quarter of 2013 pushed the year-over-year pace to its highest level in six years. This is a level of growth that certainly supports an eventual hawkish turn. The question is whether it supports expectations of a BoE hike in the coming months. For speculators, the data was merely ‘in-line’. Yields and swaps rate were notably little moved. When strong data doesn’t support bulls.
New Zealand dollar: A Rate Decision Not to Overlook
There are two major monetary policy gatherings over the coming session. Most will focus on the FOMC – for good reason – but the Reserve Bank of New Zealand’s (RBNZ)may prove just as remarkable. There is considerable disparity in expectations for this event. Though Governor Wheeler remarked last month that he expected rates would be 225 bps higher by 1Q 2016, speculation of the first move is notably absent. Swaps see a 34 percent chance of a hike for the 2.50 percent benchmark rate today. Even if they hike, broader risk trends may be an issue.
Euro: Another Sign that Liquidity is Getting Tight
The European Central Bank (ECB) once against failed to sterilize the more than €170 Billion in government bonds it holds from its rescue efforts over the past few years. That is the second time this year – another addition to a series of nagging concerns that liquidity troubles are bubbling to the surface once again. While the overnight market rate (EONIA) has been cut in half from last week, it is still notably elevated. Meanwhile, economic data is far from impressive for the Eurozone, standoffs with Greece continue and bailed EZ members are casting off support lines.
Yen Crosses Advance after Emerging Markets Jump
In the scale of risk sensitivity, the yen crosses are proving to be one of the more susceptible areas of the FX market to fading risk trends. The yen advanced against all its counterparts (the crosses slid) this past session. The upcoming FOMC decision is a clear volatility risk as the Emerging Market’s recent effort at stability leaves much to be desired. There is significant options positioning around spot warning of volatility.
Canadian dollar Now Suffering Even During Risk Bounce
A Citi research note earlier this week remarked that loonie selling pressures over the past four weeks have been the strongest they had to record. That anecdote certainly fits with the performance of the currency. Risk trends have bounced this week, with both the Aussie and Kiwi dollars taking advantage. And yet, the Canadian currency has declined to partake in the buoyancy itself.
Emerging Markets Continue to Retrace Losses
There has been a lot of emerging market policy activity over the past 48 hours. Rate hikes from the Indian and Turkish central banks have boosted the inflation fight and Argentina’s weekend capital control efforts have looked to stem the outflow. Volatility – particularly selling pressure – has responded by cooling. But is this more a response to these cumulative efforts or regard for the upcoming event risk in the Fed…
Gold Shifts Focus from Emerging Market Stability to US Taper Schedule
As we would expect the day before the dollar faces a meaningful piece of event risk, gold was little virtually unchanged this past session. The small move was matched by an equally tepid volume level in the futures and ETF space. Meanwhile, the CBOE’s Volatility Index for the metal has continued to advance to 18.7 percent – the highest since January 8 and over 4.5 vols from the 9-month low set just last week. There is concern about the upcoming event risk and its influence on the dollar’s appeal.