Dollar: Heavy Speculation Ensures Fed Decision Volatility

DailyFX   |  June 20 2012 2:21 EDT

The prevailing winds of speculation and hope carried the dollar deeper into its correction Tuesday as traders prepared to reengage fundamentals with the upcoming Fed rate decision. It is difficult to miss the expectations and influence for the upcoming policy meeting of the world’s largest central bank.

• Dollar: Heavy Speculation Ensures Fed Decision Volatility
• Euro Faces Painful Bond Auctions, Strung Out Greek Vote and Sentiment Plunge
• British Pound Sees an Open Door for Stimulus as CPI Eases, BoE Readies Stimulus
• New Zealand Dollar: A Firm GDP Reading Would be a Good Compliment to Rates
• Japanese Yen Sees Record Foreign JGB Interest on Record 2011, Trade Near Record Low
• Gold Ready to Explode on the Fed’s Orders

Dollar: Heavy Speculation Ensures Fed Decision Volatility

The prevailing winds of speculation and hope carried the dollar deeper into its correction Tuesday as traders prepared to reengage fundamentals with the upcoming Fed rate decision. It is difficult to miss the expectations and influence for the upcoming policy meeting of the world’s largest central bank. In the past few weeks, we have seen risk-sensitive, growth-dependent assets like the S&P 500, high yield bonds and carry trade pairs post rallies between 5 and 8 percent. In turn, the safe haven (and it should be said stimulus-burdened) Dow Jones FXCM Dollar Index has dropped as much as 280 points. The level of correlation and momentum behind these different markets speaks to active speculation of Fed move that will curb building financial uncertainties and further entice side-lined market participants back into the market.

We can further garner a sense of how market moving this particular head-line event can be when we appraise the fallout from the April decision and the current distraction from other dominant, fundamental matters. Heading into the April 25 Fed gathering, there was considerable chatter within the ranks that policy group would explicitly offer options for future stimulus programs (with a smaller segment expecting an actual move). Following that mum event, the greenback soared and S&P 500 tumbled in following days and weeks. The stakes are even higher this time around. Not only is the outlook for global growth deteriorating, but the spread of financial trouble from the Euro Zone to the rest of the world bolsters the need for supranatural support from the most prolific stimulus provider. If assistance isn’t offered, the premium will drop fast.

That leads us to the possible scenariosfor this event and the expected market impact for each. First, it is important to recognize that this particular rate decision is particularly complex because in addition to the rate decision (16:30 GMT), we will also received quarterly forecasts for growth and interest rates (18:00 GMT) as well as Chairman Bernanke’s press conference (18:15 GMT). The most volatile component of this entire event is the possibility of additional stimulus. An expansion of the rescue effort would likely be announced alongside the hold in rates. With that in mind, the biggest boost to the dollar and hit to risk trends would be the absence of any additional easing (whether that be new purchases that expand the balance sheet or further ‘Operation Twist’) as it is already heavily priced into the market. Significantly less supportive of the currency but possibly unfulfilling for capital markets would be an extension of Operation Twist that sees proceeds from shorter-term Treasury sales go into purchases for longer-dated paper (though this could be further bolstered by forecasts and vows to potentially do more if needed). The most pained outcome for the dollar and supportive of the S&P 500 and other benchmarks would be a program that outright increases the Fed’s balance sheet (probably mortgage-backed securities purchases as well as some Twist).

The above is an ideal and academic assessment of how the markets would react to such developments. What matters though is how the market truly reacts to the outcome. If for example the central bank wants to pull out all the stops and offer full support, yet risk appetite fails to gain traction; we would be facing a fundamental dilemma where the marginal return for capital markets to additional stimulus has collapsed. On scales of lasting damage to sentiment, a failure to launch on the best of outcomes would be the most disastrous outcome for general risk trends.

Euro Faces Painful Bond Auctions, Strung Out Greek Vote and Sentiment Plunge

You wouldn’t know it by looking at the euro’s performance, but the fundamental backdrop was exceptionally disappointing for the shared currency this past session. Attempting to carry through the good will from the Greek vote this past weekend, a coalition has still not formed amongst the leading parties – though it seems Pasok may be content in creating a union with New Democracy and Democratic Left as Syriza remains adamant its opposition stance on bailouts. From the docket, we witnessed the Euro Zone ZEW survey(investor sentiment) suffer its biggest plunge since August in a sharp move to -20.1. And, where 10-year Spanish and Greek yieldseased on unfounded rumor that the ESM will start buying bonds post haste, we saw borrowing rates for both counties shoot higher at their respective auctions for short-term paper.

British Pound Sees an Open Door for Stimulus as CPI Eases, BoE Readies Stimulus

Despite the further distance from the Euro-area’s financial crisis than the euro itself, the sterling showed a far more mixed performance Tuesday. This could be partly due to the tempered sensitivity to flippant changes in crisis mood (with a focus on medium-term deterioration), but it also has its fundamental roots in the 30-month low for CPI (2.8 percent) and the BoE’s announcement that it would run is first emergency liquidity operation tomorrow (5 billion pounds). We’ll keep the fundamental fires burning Wednesday with the BoE minutes and job claims.

New Zealand Dollar: A Firm GDP Reading Would be a Good Compliment to Rates

The Australian dollar has shown an impressive pace on its rebound because its overly dovish outlook for rates retraced alongside risk trends themselves. For the Canadian dollar, reticence is a reflection of the currency’s poor positioning on the carry spectrum. In comparison, the kiwi dollar is leading the major’s comm bloc. Where the Aussie has to find a relief rally from its oversold position, the kiwi is looking at the most reserved rate cut outlook in six weeks. Add to that a premium on bond yields and an upcoming GDP release, and you have an interesting read.

Japanese Yen Sees Record Foreign JGB Interest on Record 2011, Trade Near Record Low

There is no doubting where the Japanese yen’s attention is – on risk trends and the heavy volatility potential in the upcoming Fed rate decision. However, it is worth taking stock of the fundamental developments that will carry beyond a short-term swing in risk appetite. From the headlines we learned that there was a record foreign interest in JGBs through 2011 with outsiders holding 8.3 percent of the total market – demand to keep the yen up. Furthermore, we saw this morning that the May trade deficit hit its third highest on record – a long-term weight.

Gold Ready to Explode on the Fed’s Orders

There are many assets that we can watch for the Fed decision fallout – and ultimately, you should watch what you are trading. Yet, whether you plan to trade it or not, gold will be a very interesting player in the upcoming event risk. As an explicit alternative to traditional stores of wealth (currency and government debt) as well as a traditional safe haven, this commodity could be in for some exceptional volatility.

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--- Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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