By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Trading FOMC Is Not A Simple Binary Bet
While there’s a 28% chance of a this week according to Fed fund futures, 50% of the 102 economists surveyed by Bloomberg are looking for liftoff to begin this month. For some, the disconnect makes for difficult positioning but we believe that the lack of agreement motivates investors to take profit and/or reduce positions ahead of the FOMC rate decision. We have already seen the dollar decline versus the at the start of the week and believe that profit taking is one of the main reasons why the lost value on Monday for the first time in 7 trading days.
Unfortunately trading the FOMC rate decision is not a simple binary bet of hike vs. no hike. There are at least 4 different options for the Fed and in each of these scenarios, we expect a one-two move in the currency. The first move will be a knee-jerk reaction to the rate decision and the second will be driven by guidance.
Here’s a brief guide to four of the most likely scenarios with indications on how the could react. We’ll talk about these more as the week progresses.
- Hike but imply that they are one and done for the year > Initial USD spike followed by vicious reversal
- No hike but indicate that rates will still rise this year > Initial USD drop followed by healthy relief rally
- No hike and no guidance on when rates would rise > Multi-day decline in USD
- Hike and indicate that more could come in 2015 if headwinds fade and US economy strengthens > Multi-day rally in USD
We are advising our clients to sell U.S. dollars ahead of FOMC, square up on the day of the event and wait for new opportunities after the announcement. Chances are that will trigger an explosion in and a break of trading ranges for many currency pairs.
could slip as far down as 119 ahead of the FOMC rate decision if the Bank of Japan leaves and signals no plan to increase Quantitative Easing Monday night. Unfortunately, that's a big 'IF' because Japanese government officials have been calling for more QE given the low level of inflation and patchy growth. The BoJ has moved further away from meeting its goal of 2% inflation so while the chance of an increase Monday was very slim, the central bank could suggest it is open to the idea of more monetary stimulus, which would be negative for the Japanese yen. However policymakers may want to see the updated growth and inflation forecasts at the end of October before shifting their guidance. Waiting until next month also allows them to see how the market reacts to September's FOMC announcement.
The Australian dollar was the best-performing currency Monday, rising against all of the major currencies. This was not only the third straight day of gains for the currency pair but the rally took 2 pips away from its September high. Stronger-than-expected Chinese contributed to the move although we can’t get too excited about the data with and falling short of expectations. The also ended the day down 2.67%. Nonetheless it seems that the recent recovery in and last week’s better-than-expected encouraged profit taking on short AUD positions.
AUD traders also celebrated Tony Abbott’s loss of power. Malcolm Turnbull defeated Tony Abbott in Sunday night’s polls to become the new Prime Minister of Australia. However Turnbull won by a very small margin and internal divisions within his party could lead to continued political uncertainty.
Monday night’s will be the real test for AUD/USD. The central bank left at its last meeting and provided no fresh guidance on monetary policy. Initially the Australian dollar spiked higher because the RBA did not express any direct reservations about China but ended the day in negative territory as investors priced in another round of easing. If the concerns surface in the minutes, AUD could give up its gains quickly.
Meanwhile EUR/USD rejected 1.14, a level that has hampered gains on a number of occasions in February, May and June. Euro traders ignored the larger increase in to trade lower on risk aversion, profit taking and a reversion of the EUR/USD trading range. The German is scheduled for release Tuesday and while we are looking for an improvement in sentiment, we do not believe the report will have a significant impact on EUR/USD.
In contrast, ended the day virtually unchanged versus the greenback. Hawkish comments from Bank of England Monetary Policy Committee member Weale lent support to the currency. He called for a rate hike “relatively soon,” saying that “With wage growth remaining firm, the tightening labour market means that inflation is likely to rise above target in two to three years’ time. Policy needs to be set with reference to this, rather than the current rate of inflation. As a result, it seems likely to me that the Bank Rate will need to rise relatively soon.” Although Weale is one of the more hawkish members of the central bank, he did not vote for a rate hike at the last meeting and these comments suggest he could do so in the coming months.
This is a very important week for the British pound with , and data scheduled for release. While nearly all of these reports are expected to show weakness in the economy, sterling is trading well because investors, economists and central banks are hoping that will rise.
Lower and a slowdown in prevented the Canadian dollar from incurring more gains. has been trading in a narrow range for the past 3 weeks and the latest developments encouraged further consolidation.
Finally, the traded slightly higher on the back of stronger activity. While the Reserve Bank last week and talked of doing more, both - and -sector activity increased in August. This week’s and numbers should explain why the central bank felt it was necessary to cut rates three meetings in a row.
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