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U.S. Dollar: Positioning Ahead FOMC

Last updated 12/15/2009 4:06 PM ET (GMT -5) 3 Comments

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• U.S. DOLLAR: POSITIONING AHEAD FOMC
• EUR: EUROZONE PLAGUED WITH ITS OWN PROBLEMS
• GBP: SAVED BY HOT CPI
• AUD: RBA OPEN TO A PAUSE IN FEB?
• CAD: LEADING INDICATORS HITS 22 YR HIGH
• NZD: OIL PRICES RISE, GOLD FALLS
• JPY: TRADING OFF FUNDAMENTALS AND NOT RISK APPETITE

EXPECTATIONS FOR UPCOMING FED MEETINGS

U.S. DOLLAR: POSITIONING AHEAD FOMC

The U.S. dollar rose to a 2 month high against the euro ahead of the Federal Reserve’s monetary policy announcement on Wednesday. Based upon the price action in the forex, equity and bond markets, traders across different asset classes are all positioning for a hawkish outcome from the Fed. This suggests that if there was a disappointment, it would come in the form of an unchanged rather than hawkish monetary policy statement. However this does not mean that a hawkish statement would elicit a weaker reaction in the forex market than a dovish statement because currency traders are not over weighted U.S. dollars. Instead, the tone of FOMC decision should determine how the dollar trades for the remainder of the year. 

What to Expect from the Fed

The 3 things that investors will be looking for tomorrow will be the tone of the FOMC statement, changes to the discount rate and any plans to end emergency programs. The sharp moderation in job losses and improvement in consumer spending will encourage the Federal Reserve to grow more comfortable with the outlook for the U.S. economy. However there are still plenty of reasons why the Fed may not want to appear overly hawkish and therefore quite a bit of uncertainty rests with tomorrow’s FOMC statement. We only expect the bare minimum from the Fed because they realize that at this critical juncture in the U.S. recovery, there are more consequences than benefits to being overly hawkish. Although we believe that the Fed will underwhelm, dollar bulls may not need much to be satisfied and therefore any subtle changes to the language of the FOMC statement could affect how the dollar trades. A more upbeat tone by the Fed would be positive for the dollar while skepticism about the sustainability of the improvements in the labor market or consumer spending could reverse the greenback’s recent gains. For more on these 3 items that the market wants the Fed to address, read our FOMC Preview .

Economic Data: Good News and Bad News

Meanwhile a round of mixed U.S. economic data has not stopped the dollar from rising. Producer prices which measures wholesale level inflation increased 1.8 percent in November with core prices rising 0.5 percent. On an annualized basis, PPI rose by the strongest pace since October 2008. Unsurprisingly, the weakness of the U.S. dollar, rise in gasoline and other energy prices played a big role in pushing PPI higher but aside from a drop in the price of passenger cars and computers, stronger price pressures was seen everywhere. However unlike oil prices, gas prices fell gradually last month which means that even though we also expect consumer prices which are due for release tomorrow to rise, the pace of growth may not be as strong as PPI. Stronger inflationary pressures, a pickup in consumer spending and a dramatic improvement in the labor market should encourage the Fed to adopt a more hawkish tone on Wednesday. Unfortunately the sharp drop in the Empire State Manufacturing survey will make it difficult for the Fed to be anything more than cautiously optimistic. The index fell from 23.51 to a five month low of 2.55 which indicates that manufacturing activity slowed significantly last month. The only saving grace is the rise in industrial production in November and the increase in capacity utilization which suggests that the slowdown in the NY region may be unique to the Empire State. The Treasury International Capital flow report was conflicting with demand for long term securities increasing but demand for short term securities falling. However the key takeaway is that foreign officials which include central banks boosted their holdings of U.S. dollars by $14.6B, the largest increase in 4 months. Aside from CPI, the current account balance for the third quarter, housing starts and building permits are also due for release. The decline in the NAHB housing market index which measures builder confidence suggests that that like the manufacturing sector, the pace of activity in the housing market may have slowed.

EUR: EUROZONE PLAGUED WITH ITS OWN PROBLEMS

The euro came under aggressive selling pressure this morning after reports suggested that Austria may be the latest trouble spot in the region. The single currency has recently been hit from all sides as deteriorating finances in Greece and Ireland raise concerns about the fiscal health of the entire region. With Austria coming under the microscope, investors have chosen to sell first and assess the situation later. For the EUR/USD, there are many fundamental reasons behind the currency pair’s latest weakness. The structural problems in the Eurozone stem primarily from exposure to Eastern Europe, a strong euro, rising debt and growing deficits.  On the other hand, the dollar has also strengthened on the heels of stronger economic data. Although we do not believe that these problems will break up the Eurozone, which would have dire consequences for the entire region, it will make investors less confident about holding euros.  Economic data added further pressure on the currency. Investors were the least pessimistic about current conditions in Germany in 15 months but also the least optimistic about future conditions in 5 months. The ZEW index fell from 51.1 to 50.4 in the month of December, indicating that the slowdown in growth has taken a bite out confidence. Manufacturing and service sector PMI numbers are due for release tomorrow. Given the drop in industrial production and factory orders, we expect a weaker expansion in both sectors of the economy. Meanwhile the Swiss franc has shrugged off the government’s upgraded GDP forecasts and stronger industrial production numbers. Back in September, the State Secretariat for Economic Affairs (SECO) originally forecasted GDP to decline by 1.7 percent in 2009 and to increase by 0.4 percent in 2010. Now they only expect a 1.6 percent decline in GDP followed by a 0.7 percent increase in growth the following year.

GBP: SAVED BY HOT CPI

Although the British pound also fell victim to broad dollar strength, compared to higher yielding currencies such as the euro, Australian and New Zealand dollars, its decline was modest. Sterling’s resilience was partially tied to the stronger consumer price index which rose 0.3 percent last month, driving the annualized pace of CPI growth to 1.9 percent from 1.5 percent, the fastest pace of growth since May. As usual, energy prices are to blame. Given that the central bank has an inflation target of 2 percent, the recent pickup in price pressures reduces the chance of further Quantitative Easing.  The BoE has previously predicted that inflation could rise as much as 3 percent next year and if they want to reduce the risk of inflation overshooting, it would be more suitable to reduce rather than increase the size of their QE program. Chancellor Darling also eased concerns about the U.K. following in the footsteps of Greece and Ireland by saying that he had “no concerns” about a rating downgrade. Looking ahead, employment numbers are due for release and based upon the manufacturing and service sector PMI reports, job losses should have moderated in the month of November. 

AUD: RBA OPEN TO A PAUSE IN FEB?

Of the three commodity currencies, the biggest loser was the Australian dollar which was sold on the belief that the Reserve Bank of Australia could leave interest rates on hold in February. Last night, the RBA released the minutes from their most recent monetary policy meeting at which they raised interest rates 3 times in a row.  Instead of stressing the urgent need for additional tightening to prevent another bubble, the RBA said that their 3 rate hikes will give them “greater flexibility” at future policy meetings. Traders have interpreted these 2 words to mean that the central bank could pause at their next monetary policy meeting. Although this is certainly a possibility, a pause would not put the RBA off the path of additional tightening. The RBA board still believes that interest rates are “too low for an economy that had resumed expanding” in 2009. With 2 full months between the previous and next monetary policy meeting, the central bank wants to leave all of their options open because a lot of economic data will be released during that time. One of those economic reports will be tonight’s GDP numbers. Third quarter growth is expected to slow as retail sales and trade decline. RBA Deputy Governor Battelino will also be giving a speech and Aussie traders should listen closely to see if he echoes the sentiment in the minutes. Meanwhile the currency that dropped the least was the Canadian dollar which managed to hold onto its gains thanks to stronger economic data. Leading indicators rose 1.3 percent in November the fastest pace of growth in 22 years while new motor sales increased 3.5 percent. 

JPY: TRADING OFF FUNDAMENTALS AND NOT RISK APPETITE

The sharp rally in USD/JPY has helped to lift all of the Japanese Yen crosses. There was no Japanese economic data released overnight and the Nikkei was virtually unchanged which means that the move in the currency pair was driven entirely by demand for U.S. dollars. This evening, the tertiary industry index and machine tool orders are the only pieces of economic data due for release from Japan and should not be market moving for the Yen. Instead, the U.S. economic reports in the morning and the outcome of the FOMC rate decision will determine how USD/JPY and the other Yen crosses trade in the coming days. Interestingly enough, this week USD/JPY has decoupled from U.S. equities.   USD/JPY was the strongest performing major currency pair today even though stocks declined. This divergence indicates that currency traders are keying off of fundamentals and not risk appetite. In our special report on Monday, we indicated that good data is finally helping the dollar, a dynamic that we have not witnessed in months.  

EUR/USD: Currency in Play for Next 24 Hours

The currency in play for the next 24 hours is the EUR/USD. Manufacturing and service sector PMI data from the Eurozone will be released between 8:30GMT / 3:30AM EST and 4:00 GMT / 9:30 EST. The U.S. will release consumer prices, housing starts, building permits and current account at 13:30GMT or 8:30AM EST followed by the FOMC monetary policy announcement at 19:15 GMT or 2:15pm EST. 

For the past 2 weeks, the EUR/USD has been trading comfortably within the Sell Zone, which we determine using Bollinger Bands. As long as the currency pair remains in this zone, the odds are skewed towards greater weakness than strength.  Although 1.45 is a significant psychological support level for the EUR/USD, 1.44 is the true technical support as it represents the former breakout point back in September. If the Federal Reserve is hawkish enough to satisfy dollar bulls, expect this level to be tested. However if they fall short of market expectations and remains cautious, the EUR/USD could rebound back above the 100-day SMA at 1.4650.

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Comments (3)

Hari

December 16, 2009 at 03:07 AM ET

At what time FOMC news will be released at 19:15 GMT or 20:15 GMT. Pl confirm.

alexjbrandt

December 16, 2009 at 07:31 AM ET

I think the FOMC will disappoint dollar bulls. If I was the Fed, I would wait till I saw a continued and sustained improvement in the US economy on a quarterly basis such as a increase in consumer spending , employment rate, and bank lending to change stance.

Triffany

December 16, 2009 at 07:53 AM ET

Alex, I agree. With "Continued and sustained" being the operative words. I think the US economy is on the mend, but I think it is going to take a long time to really stabilize and prove itself.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.