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EUR/USD: Trading the FOMC Interest Rate Decision

Wed, Mar 18 2009, 05:54 GMT
by Daily FX Research Team

DailyFX

The Federal Reserve is widely expected to hold the benchmark interest rate steady at the record low this month as policy makers attempt to steer the world’s largest economy out of a deepening recession, and may expand its purchases of asset-backed securities as the outlook for growth and inflation falter.

Trading the News: FOMC Interest Rate Decision

What’s Expected

Time of release: 03/18/2009 18:15 GMT, 14:15 EST

Primary Pair Impact : EURUSD

Expected: 0.25%

Previous: 0.25%

Effect the FOMC rate decision had over EURUSD for the past 2 months

The FOMC held borrowing costs at the record low in January, and said that the central bank has arranged to purchase ‘longer-term Treasury securities’ in an effort to ‘support the functioning of the financial market.’ The extraordinary efforts taken on by the MPC has inflated the Fed’s balance sheet by more than $1T, and the central bank expects the figures to say at a ‘high level’ as they attempt to jump-start the ailing economy. The minutes of the board meeting showed that Richmond Fed President Jeffrey Lacker was the only dissenter to oppose the new policy objectives taken on by the FOMC, and said that he prefers buying ‘Treasuries rather than through targeted credit programs.’ Meanwhile, the board also saw ‘some risk’ for deflation as they expect price growth to hold below the 2% target over the next two years, and may continue to expand the money supply at a rapid pace to stem the downside risks for inflation.

December 2008 FOMC Rate Decision

The Federal Reserve lowered the benchmark interest rate to a target range of zero and 0.25% for the first time in its history as they saw ‘substantial’ downside risks for growth, and went on to say that the central bank may keep borrowing costs at the record low ‘for some time’ as the economy faces its longest recession in over a quarter century. The committee said that they will consider ‘various quantitative measures’ in an effort to foster economic activity, and discussed setting near-term price targets in order to anchor the outlook for inflation. The FOMC did not present a growth forecast for 2009, but said that the Fed’s ‘balance sheet would need to be maintained at a high level’ as the central bank adopt a zero interest rate policy, and said that they ‘will employ all available tools’ as the MPC maintains their dual mandate to ensure price stability while supporting economic growth.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario:

If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the Euro against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on EURUSD ahead of the data release.

Bearish Scenario:

If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the Euro against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on EURUSD ahead of the data release.

How To Trade This Event Risk

The Federal Reserve is widely expected to hold the benchmark interest rate steady at the record low this month as policy makers attempt to steer the world’s largest economy out of a deepening recession, and may expand its purchases of asset-backed securities as the outlook for growth and inflation falter. The preliminary GDP reading for the fourth quarter showed that the annual rate of growth contracted the most since 1982, while personal consumption dropped 4.3% from the third quarter to mark the largest drop in private-spending since 1980, and conditions are likely to get worse as households turn increasingly pessimistic towards the economy. A report by the Conference Board showed that consumer confidence fell to its lowest level since recordkeeping began in 1967, which foreshadows a weakening outlook for personal spending, and growth prospects are likely to deteriorate further as the labor market weakens at a record pace. U.S. non-farm payrolls plunged another 651K in February following a 655K drop in the previous month - the biggest contraction since 1949 - and marked the worst slump in employment since recordkeeping began in 1939. As a result, the annual rate of unemployment surged to a 26-year high of 8.1% from 7.6% in January, and the data continues to reinforce fears of a deepening recession as firms continue to cut back on spending and employment in an effort to reduce costs. Meanwhile, falling price pressures continued to raise the risks for deflation as the core personal consumption expenditures price index slipped below the Fed’s 2% target to reach an annualized rate of 1.6% from 1.7% in December, and as the central bank expect price growth to remain subdued over the next two-years, policy makers could be forced to take an aggressive approach to shore up the economy as credit conditions remain far from normal. Nevertheless, Fed Chairman Ben Bernanke reinforced hopes for a speedy recovery during an interview on Sunday, stating that ‘the recession will probably end this year and the economy will expand in 2010’ if policy makers succeed in stabilizing the financial markets however, as investors continue to weigh the viability of U.S. banks, the FOMC may opt to step up its rate of purchase as the banking industry remains under pressure. Moreover, market participants have argued that the drop in the Fed’s balance sheet to $1.90T from $2.31T in December underscores fading demands for the central bank’s lending procedures currently in place, which could lead the board to shift into overdrive as they employ all of their available tools to avoid a deepening downturn in the economy. Despite the unprecedented measures taken on by the government and the central bank, as investors remain risk adverse, the U.S. dollar is likely to hold its bullish trend against its counterparts over the near-term as the reserve currency continues to reap the benefits of its safe-haven status.

Trading the given event risk may not be as clear cut as some of our other trades as investors expect the Fed to hold rates steady however, commentary following the rate decision is likely to spark volatility in the U.S. dollar as market participants weigh the effectiveness of the new policy. Therefore, if the FOMC fails to expand its rate of purchases, we should see a rise in risk aversion as investors remain skeptical of the central bank’s approach to stimulate the economy, and will look for a red, five-minute candle following the release to generate a sell entry on two lots of EURUSD. Once these conditions are met, we will place our initial stop at the nearby swing high (or reasonable distance taking volatility into account), and this risk will determine our first target. Our second target will be based on discretion, and in an effort to preserve our profits, we will move the stop on the second lot to breakeven once the first trade reaches its target.

On the other hand, mounting turmoil in the banking sector paired with a dour outlook for growth and inflation could lead the committee to set up their efforts to jump-start the economy, and may opt to increase its rate of purchase as the economy faces a deepening recession. As a result, if the FOMC addresses the need for further action and states that they will boost purchases of asset-backed securities, a rise in risk appetite would lead us to short the greenback, and we will follow the same strategy for a long euro-dollar trade as the short position mentioned above, just in reverse.

Published on  Wed, Mar 18 2009, 08:08 GMT