FOMC could be the trigger to the next dollar bull run

Macro Outlook

Janet Yellen and the FOMC find themselves in a curious position this week. The committee is set to finally finish its tapering of asset purchases and bring to a close its programme of quantitative easing that has been winding down throughout most of this year. There has been speculation from some non-voting FOMC members (especially arch-dove, James Bullard) that the Fed might look to continue with asset purchases, but the signal that this sends out to the market would probably do more harm than good. The “taper tantrum” was apportioned some of the blame to the recent sell-off on equity markets, but aside from having to cope with the volatility spike over the past few weeks, the ability of Wall Street to rebound strongly remains an impressive trait. The Fed Funds futures were pushed back by around 6 months (as the market priced in Q1 2016 for the first rate hike), however what if the Fed broadly stands pat on its guidance, ends QE this week and does not significantly change the “dot plot” to take account of a slower rate hikes? This could drive another bout of dollar strength as the market realises that perhaps the Fed Funds futures are suddenly priced too dovishly. It could be another week packed with volatility in the markets.

Must watch for: FOMC monetary policy & statement

Impact: At the end of a month where markets have swung violently, perhaps this FOMC meeting is even more crucial than normal. Until recently, rhetoric from various FOMC members has been shifting towards a slightly more hawkish stance, whilst the “dot plot” of interest rate expectations has suggested that once tightening begins, the hikes will be steeper than previously thought. This has driven dollar strength. However, volatility, market shocks, concerns over the Eurozone, China and even signs of a negative impact on the US, could result in a more dovish tone to the statement. Expect more dollar volatility.

Foreign Exchange

The outlook for the dollar has been rather mixed of late, meaning that there have been a number of false signals on some of the major forex pairs. This has meant that forex trading has been choppy, but the Dollar Index has been starting to push higher once more (despite Friday’s slight dip). A break above resistance at 86.01 this week could be a signal for the next bull run to begin. If Dollar/Yen is anything to go by then the bulls are already making their move, with a bullish breakout last week a medium term buy trigger. The Euro and Sterling have been hanging on by the skin of their teeth amid the strengthening dollar, but there is a raft of data releases that could impact throughout the week which could drive the dollar higher once more. A disappointing German Ifo Business Climate could heap early pressure back on the euro, whilst the FOMC could trigger the next bout of dollar strength if it retains its recent stance.

WATCH FOR: Volatility on the Euro/Dollar pair throughout the week, starting with euro traders closely watching the German Ifo and flash CPI inflation readings for Germany and the wider Eurozone. Dollar traders will be focused on the FOMC meeting and followed quickly on Thursday with the Advance reading of US Q3 GDP. Yen traders will be looking for any potential dovish signals from the BoJ on Friday.

Indices

This has been an incredible rebound in equity markets over the past week or so. Once more, it appears as though the reversal following a spike higher in the VIX Volatility Index has coincided with a major market low. Equity markets have moved higher as the perception of the need to cover equity portfolios using downside insurance (ie. S&P 500 put options) has subsided. Equity markets have bottomed and risen almost as fast as they fell. The S&P 500 is now over 7% off its low at 1820, whilst the DAX is almost 8% higher off its low at 8355 and the CAC 40 is 9% off its low at 3789. However, no prizes for guessing the major index that has lagged the recovery. The FTSE 100 has bounced just over 5%. As has so often been the case throughout 2014, on a relative basis the FTSE 100 has performed well during the market’s selling phases, however has lagged (sometimes quite badly) during the bull phases. This is especially true when compared to the German DAX. Key reasons behind this would be the significant impact that Russian sanctions is having on Germany meaning that the elastic has a lot more to snap back once the bulls take charge after the selling pressure abates.

WATCH FOR: The German Ifo could set the tone for the early part of the week, whilst German CPI will also be keenly watched in Europe. US consumer confidence will be interesting after the recent market shocks and could drive sentiment on Tuesday. The FOMC meeting will be crucial to assess the Fed’s outlook for the US economy and is sure to drive sentiment on Wednesday evening and into Thursday.

Other Assets: Commodities & Bonds

As the dollar has recently consolidated, the downside pressure on the oil price reduced and the price has been able to consolidate. However, the dollar is now beginning to show signs of building for the next upside break once more. This is putting pressure back on the price of WTI and Brent. The supports at $80 on WTI and $82.60 on Brent Crude are key now. Although oil supplies show little sign of reducing, the lack of demand has been a key diver of lower prices, and is seen by some as a proxy for market risk. Another downside break could be seen as a negative sign for global demand and result in a flight into safe haven assets once more.

After spiking higher a couple of weeks ago amid the height of risk aversion, the Eurozone Core/Periphery 10 year yield spread of sovereign debt continues to unwind. However the peripheries have not entirely unwound yet. The spread of Italian yields over the Bund is still up at levels not seen since July 2013, with the Spanish yield is also still elevated. So there is still room for the spread to correct.

WATCH FOR: Commodity prices will react to tier 1 US economic data such as the FOMC and Q3 GDP data, whilst sovereign debt traders will be looking out for German and Eurozone CPI and also the FOMC.