Forex: Trading FOMC is Not a Simple Binary Bet

There's a 28% chance of a Federal Reserve rate hike this week according to Fed fund futures but 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 Japanese Yen at the start of the week and believe that profit taking is one of the main reasons why the EUR/USD 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 on four of the most likely scenarios with indications on how the dollar could react. We'll talk about these more as the week progresses.

1.  Hike but imply that they are one and done for the year > Initial USD spike followed by vicious reversal

2.  No hike but indicate that rates will still rise this year > Initial USD drop followed by healthy relief rally

3.  No hike and no guidance on when rates would rise > Multi-day decline in USD

4.  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 Janet Yellen's testimony will trigger an explosion in volatility and break of trading ranges for many currency pairs.

USD/JPY could slip as far down as 119 ahead of the FOMC rate decision if the Bank of Japan leaves monetary policy unchanged and signals no plan to increase Quantitative Easing tonight.  That is a big IF unfortunately 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 their goal of 2% inflation so while the chance of an increase tonight is very slim, the central bank could suggest they are 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 the September FOMC announcement.   

The Australian dollar was the best performing currency today, 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 AUD/USD 2 pips away from its September high.  Stronger than expected Chinese retail sales contributed to the move although we can't get too excited about the data with industrial production and fixed assets growth falling short of expectations.  The Shanghai Composite Index also ended the day down 2.67%. Nonetheless it seems that the recent recovery in copper prices and last week's better than expected employment report encouraged profit taking on short AUD positions.

AUD traders also celebrated Tony Abbott's loss of power.  Malcolm Turnbull defeated Tony Abbott in last 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.

Tonight's RBA minutes will be the real test for AUD/USD.  The central bank left interest rates unchanged at their 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 industrial production to trade lower on risk aversion, profit taking and a reversion of the EUR/USD trading range.  The German ZEW survey is scheduled for release tomorrow 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, Sterling 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 inflation, spending and employment 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 earnings will rise.

Lower oil prices and slowdown in house price growth prevented the Canadian dollar from incurring more gains. USD/CAD has been trading in a narrow range for the past 3 weeks and the latest developments encouraged further consolidation.

Finally, the New Zealand dollar traded slightly higher on the back of stronger service sector activity.  While the Reserve Bank lowered interest rates last week and talked of doing more, both manufacturing and service sector activity increased in the month of August.  This week's current account and GDP numbers should explain why the central bank felt it was necessary to cut rates three meetings in a row.