The Risk Of A Fed Disappointment

FOMC And The Risk Of Disappointment

Wednesday's Federal Reserve monetary policy announcement is one of the most anticipated events of the year and expectations are running high for the first reduction in asset purchases since Quantitative Easing was first introduced in 2008.  Even if the Fed refrains from tapering, investors expect them to reduce monthly bond buys in January or March at the very latest. The problem is that when the bar is set high, there is always the risk of disappointment.  According to the latest CFTC IMM reports, speculators are holding massive amounts of long dollar positions against the JPY, AUD and CAD.  If the central bank fails to be as hawkish as the market expects, profit taking on those positions could drive the dollar quickly and aggressively lower even if the Fed ends up being one of the few central banks unwinding stimulus next year.

The worst outcome for the dollar would be if the Fed says no to tapering and forward guidance. By standing down completely and providing zero forward guidance, Bernanke would effectively be telling us that he is relegating the decision to his successor.  The market would expect Janet Yellen, who is one of the most dovish members of the FOMC to prolong Quantitative Easing and delay tapering.  While there have been broad based improvements in the labor market and consumer spending, this morning's consumer price report shows that inflation is low giving policymakers the option to wait because inflation is not a major risk.  The housing market has also been mixed but more importantly, stronger manufacturing activity is offset by slower growth in the service sector. U.S. yields have increased significantly over the past 7 weeks and by tapering, the central bank risks driving 10-year yields to 3%. Based on the price action in currencies and Treasuries, investors have priced in tapering in December or January, so if there is reason to believe that it will delayed to March or April, they will need to adjust their positions accordingly which means a sell-off in the dollar, rise in U.S. stocks and decline in yields.

Thankfully this is a low probability scenario -- for more likely options, read our special report on Will the Fed Drive the Dollar Higher? 4 Options and Scenarios

• Scenario #1 - No Taper, No Guidance, Decision Pushed to 2014
• Scenario #2 - No Taper, Signals Plan to Reduce Purchases in Early 2014
• Scenario #3 - Taper $5 - $10B, No Guidance > Mildly Bullish USD
• Scenario #4 - Taper $15B - $20B, Strong Forward Guidance

Both the FOMC rate decision and the latest forecasts for growth and inflation will be released at 2pm ET / 19 GMT.  Bernanke's press conference begins 30 minutes later.  We should have a good sense of the central bank's forward guidance within the first 15 minutes of the question and answer session if not sooner.  Post FOMC trades should not be placed until the Fed's forward guidance is clear.

EUR: Prime For A Breakout?

The euro ended the North American trading session within 70 pips of its 2-year high against the U.S. dollar.  The recent consolidation in the currency pair suggests that it is prime for a breakout and the direction of the break will be determined by Wednesday's Federal Reserve monetary policy decision.  While we have seen improvements in the German economy, the lack of breadth in the Eurozone recovery still leaves the ECB dovish.  Investors are looking for another dose of stimulus from the central bank next year and the warning from policymakers that they stand ready to provide more stimulus if the economy needs it supports these views. Nonetheless, if the Fed disappoints, EUR/USD could trade sharply higher, especially if U.S. stocks rally.  The strength of the euro is also supported by stronger investor confidence.  According to latest ZEW surveys investors have the most positive outlook for Germany since April 2006 and for the Eurozone since March 2004.  The German IFO report is scheduled for release Wednesday and given the rise in manufacturing PMI and the uptick in the ZEW, we are looking for a stronger release that could add a few pips to EUR/USD before the FOMC announcement.

GBP: BoE Minutes Should Show No Urgency To Raise Rates

Softer than expected inflationary pressures drove the British pound lower against the U.S. dollar and euro.  As we indicated in yesterday's note, inflation is not a problem for the U.K at this time.  Consumer prices grew a mere 0.1% in the month of November, pushing the annualized pace of growth down to 2.1%, the lowest year over year rise since 2009. CPI may be higher than the central bank's target but it is trending downwards. Producer prices also dropped more than expected, a sign that price pressures in the U.K. are abating.  The lack of inflation makes the Bank of England more comfortable with keeping monetary policy easy.  The minutes from their last meeting will be released Wednesday and while we expect more optimism, the MPC is in no rush to raise rates.  In addition to the BoE minutes, the U.K. will also release its labor market numbers.  Jobless claims are expected to fall at a reasonable rate that should push the claimant count rate lower. Average hourly earnings should rise as the economy continues to recover.  Optimism from the BoE and stronger data could lend support to the currency but any benefit will be short lived as investors shift their focus to the FOMC announcement.

AUD: Drops To 4-Month Lows On AUD/NZD Selling

The Australian dollar extended its losses against the U.S. dollar Tuesday, to its weakest level in 4 months. Despite an uptick in the leading index and relatively benign RBA minutes, investors appear to be aiming for Central Bank Governor Glenn Steven's 85 cent target.  The slide in AUD/USD was driven mostly by demand for NZD vs. AUD. The AUD/NZD currency pair dropped to fresh 5-year lows after the New Zealand government released better than expected fiscal finances.  New Zealand reported a larger surplus overnight and recently upgraded their GDP forecasts.  In contrast, Australia is running a budget deficit and recently said growth should be below trend.  This divergence is putting significant pressure on AUD/NZD and the sell-off could accelerate depending on the outcome of Stevens' Tuesday-night speech or if New Zealand's third quarter GDP numbers surprise to the upside.  Given stronger fiscal finances, it is no surprise that the New Zealand dollar is trading higher. The Canadian dollar traded slightly lower against the greenback, ignoring the uptick in manufacturing sales.

JPY Crosses Sell Off Ahead Of FOMC

The Japanese Yen traded higher against all of the major currencies ahead of the FOMC announcement.  USD/JPY slipped to 102.50 but managed to hold above this level, keeping the overall uptrend intact.  The biggest loser was AUD/JPY followed by GBP/JPY and we believe that the former is vulnerable to the steepest losses if USD/JPY sells off on FOMC.  Despite the recovery in the Nikkei, the drop in U.S. bond yields prevented the yen crosses from rallying.  No economic data was released from Japan last night but the trade balance is due for release Tuesday evening.  The Yen weakened significantly in the month of November but economists are looking for a wider trade deficit because the lower currency makes oil imports more expensive.  We will be keeping a close eye on the export and import numbers because they will give us the best sense of how the economy is faring.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.