Forecast for US Dollar: Neutral
The event dollar traders – and really investors in all asset classes – have long waited for is finally upon us. Speculation surrounding the FOMC’s Taper decision has run rampant, spurring expectations and fear of an explosive reaction to a big shift in the market’s support structure. In fact, the discussion over this inevitable event has proven so prolific that we have already seen forecasts amongst economists and banks establish a clear consensus for a moderation of stimulus at the September meet while yield sensitive assets (like the benchmark US Treasury) have suffered sharp adjustments. Much of the actual impact an event like this has comes through the ‘surprise’ factor, but is there any surprise left in this event? Could this be a ‘buy the rumor, sell the news’ event for the dollar?
To establish how the market responds to the Federal Reserve’s policy decision, we must establish what an ‘inline’ outcome would be. Over the past weeks and months, the members of the central bank’s board – both voters and non-voters – have repeatedly stated their support for Chairman Ben Bernanke’s timeline laid out after the June meeting – one of the quarterly events that was accompanied by updated forecasts and the press conference. With that platform, Bernanke stated that it was likely that they would begin reducing the $85 billion-per-month stimulus program (QE3) ‘later’ in 2013 and end sometime in mid-2014. Considering this is the last policy meeting with a schedule press conference until December, the first move this month would best fit the timeline.
Given the massive drop in Treasuries, mortgage backed security funds, emerging markets, gold and other yield-sensitive assets; it is clear that a tapering is being priced in. Yet, it isn’t clear as to how certain the market is of the size. The New York Federal Reserve’s survey of Primary Dealers (large financial institutions that must deal in Treasury auctions and are considered by the central bank a barometer for the market) showed expectations of a $15 billion reduction at the first meeting and an aggressive pace after a similarly-sized move in December. However, a recent Bloomberg poll showed economists only expect a $10 billion cut to Treasury purchases only. Clearly there debate over this outcome and some adjustment will follow.
In the scale of scenarios, themost overwhelming surprise would come from a decision to hold the program at $85 billion per month. An 80 percent surge in the benchmark 10-year Treasury yield in the span of just four months (not to mention the move from other global sovereign debt) shows a significant shift in expectations and positioning. If this unlikely scenario were realized, risk-sensitive assets that are dependent on the environment of artificially-low volatility would rally. However, such an outcome would be known to be a simple delay and not a permanent freeze on the necessary withdrawal. As such, risk benchmarks still hovering near record highs are unlikely to find much follow through. Carry trades that have seen an improved yield outlook (NZDUSD and AUDUSD) will progress further. Yet, perhaps the most prolific short-term rebound would come on part of US government bonds. Such a dramatic drop these past months can lead to an equally spectacular rally. In turn, a flood of capital looking to buy cheap Treasuries, could actually lift the dollar.
A Taper of approximately $10 billion along with increasingly dovish forward guidance – an effort to ‘reassure’ is guaranteed – would be the most difficult outcome to account for. There has been exceptional adjustment to this outcome in some markets but relatively little in others. The immediate volatility for the dollar with this scenario would be the most restrained. However, looking at the underlying changes this would lead to, it is likely to eventually support the dollar. An initial unwinding of ‘Taper’ premium from the greenback will be followed with counter-balances by other central banks, a rise in presumed risks and an outlook of competitive yield growth in the US.
For the most decisive support for the US dollar, a $15 billion or larger reduction alongside a status quo tone would carry the most weight. The mechanics in supporting the currency through this outcome require we tap into something far more elemental: market-wide investor sentiment. A glaring holdout to the Taper adjustment we have seen these past months, US equities led by the S&P 500 are perhaps the poster-child of ‘moral hazard’ – taking on excessive risks as participants feel they are will be absorbed by someone else. This is where the dollar’s potential really lies. If record leverage translates into disorderly unwinding the safe haven will soar.
Forecast for Euro: Neutral
The Euro broke to fresh multi-week highs against the US Dollar, but the Dow Jones FXCM Dollar Index (ticker: USDOLLAR) continues to hold key multi-month lows. All eyes now turn a highly-anticipated US Federal Reserve policy announcement to drive FX moves.
The Federal Open Market Committee (FOMC) decision on September 18 will be the major driver of currency volatility in the coming days, and European event risk is relatively limited. What could the Fed do to break the US currency and broader markets out of increasingly narrow trading ranges?
Fed Officials are widely expected to announce the start of the so-called “Taper” of the central bank’s Quantitative Easing measures. According to a Bloomberg News survey, most economists polled believe that the FOMC will cut its monthly purchases of US Treasury debt by $10 billion. Yet it’s the wide range of estimates that underlines how little we know of the Fed’s next steps. According to the same survey, 33% predict zero tapering while some anticipate as much as $20 billion in cuts.
We look to interest rate markets to guide us. US Dollar interest rate futures showed a sharp drop in Fed interest rate forecasts following a disappointing US Nonfarm Payrolls report for August. Yet the initially strong reaction to the labor data has since turned into consolidation; no one seems to be willing to make big bets ahead of the Fed.
The fact that the Euro trades near its highs and the USDOLLAR is just barely holding lows suggests that the EURUSD could break higher in the days ahead. Currency volatility has dried up in a major way, and it feels like the next big move is just around the corner.
Our retail FX sentiment-based strategies have bought into Euro strength and remain positioned for a move higher. Whether or not se see the major break depends almost completely on the Fed’s next steps. It’s difficult to predict what the FOMC might do and much less how markets might react.
In the meantime, we’ll brace ourselves for continued choppiness as currencies move in progressively smaller trading ranges.
Forecast for the British Pound: Bullish
The British Pound struggled to hold its ground during the final days of August, with the GBPUSD tagging a weekly low of 1.5426, but the Bank of England (BoE) interest rate decision may help the sterling to preserve the bullish trend dating back to July should the central bank highlight an improved outlook for the U.K. economy. Indeed, the BoE is widely expected to keep the benchmark interest rate at 0.50% while maintaining its asset-purchase program at GBP 375B, and we may see the Monetary Policy Committee refrain from releasing a policy statement should the group vote unanimously to retain its current policy.
It seems as though Governor Mark Carney is becoming upbeat on the economy as he sees a more broad-based recovery in the U.K., and the central bank head may show a greater willingness to retain the wait-and-see approach for an extended period of time as the MPC continues to operate under its inflation-targeting framework. Another 9-0 vote should help to shore up the GBPUSD as it dampens the scope of seeing a further expansion in the BoE’s balance sheet, and we may see a growing number of central bank officials scale back their dovish tone as growth and inflation picks up.
Despite the forward-guidance for monetary policy, expectations for a further rise in economic activity may heighten the outlook for inflation, and it seems as though the central bank is slowly moving away from its easing cycle as the economy gets on a more sustainable path. In turn, the inflation ‘knock out’ may become a more likely scenario for the U.K., and the BoE may take steps to ensure its credibility as price growth has held above the 2% target since December 2009.
The GBPUSD certainly appears to have carved a near-term top around the 1.5700 handle as it failed to put in a close above the 38.2% Fibonacci retracement (1.5680-90), and the relative strength index may highlight further weakness in the exchange rate as the oscillator fails to retain the bullish trend carried over from July. Nevertheless, the upward trending channel in the GBPUSD may continue to take shape should we see a material shift in the policy outlook, and the pair may continue to carve a series of higher highs paired with higher lows as market participants scale back bets for additional monetary support.
Forecast for Japanese Yen: Neutral
The Japanese Yen was the worst performing currency this past week, dropping by -1.91% to the top New Zealand Dollar, another -1.83% to the British Pound, while only a mere -0.27% to the US Dollar. Last week in this forecast I said “with the domestic tone shifting for Japan, it will be necessary for incoming growth and inflation data to remain buoyant in order for the Yen to enjoy further reprieve.”
Clearly, this was not the case. Indeed, the misses on the 2Q’13 GDP reading set the tone for a weaker Yen right from the start of trade in Asia on Monday, as signs of a weaker than expected economy leave open the door for speculation on additional easing by the Bank of Japan. As noted last week, a considerable factor for any forecasted Yen strength hinged on these growth readings besting expectations.
With the economy chugging along at an acceptable pace nevertheless (+3.8% annualized versus +3.9% expected), further chatter emerged about the prescribed sales tax hike due in the 2Q’14, with BoJ officials purportedly endorsing the fiscal measures and even offering monetary assistance should the economy see pressure. Additionally, to help offset the drawdown in consumption, the Japanese government is considering a corporate tax cut to help balance out the sales tax hike impact. In light of the fact that overall consumption here suffers – accounting for approximately 60% of Japanese GDP – these fiscal adjustments are perceived to be net-negative for the Yen.
Compounding the shakier than expected domestic picture have been positive developments on the geopolitical stage, with Russia and the US agreeing to peace talks in Geneva, Switzerland, to figure out how to strip the Syrian regime of chemical weapons. As we’ve seen over the past few weeks, any progress that reduces the threat of US military intervention has been perceived as “risk positive,” in that stocks have rallied alongside the US Dollar, while the Japanese Yen, crude oil, and precious metals have fallen. Should these tensions remain in their current state or ease further, they will likely be another negative influence for the Yen.
With little important data on the Japanese economic calendar for the coming week – only the August Trade Balance figures and the weekly domestic/foreign flow of stocks/bonds figures are of interest, and they haven’t generated truly significant price action – attention turns to the highly anticipated Federal Reserve September meeting this Wednesday.
According to consensus estimates compiled by Bloomberg News, economists are calling for a $10B reduction in the pace of QE3, with the cuts coming to Treasuries purchases, from $45B to $35B. The pace of mortgage-backed securities (MBS) purchases will remain on hold at $40B. We see the risk of a cut of $15B in Treasury purchases, which might spark a US Dollar rebound (to the Yen’s detriment). But if the cut is only $10B, and Fed Chairman Bernanke uses the press conference to reestablish forward guidance – which has been weak considering US yields are hovering near two-year highs (pre-US losing its ‘AAA’ rating) – there is a chance for a Yen rally.
The Fed is keenly aware of the risks of a 1994-esque bond market meltdown, caused by the successive, linear pace of Fed policy tightening. Accordingly, to avoid such sentiment from evolving, Chairman Bernanke and the Fed are likely to emphasize that the reduction in QE3 will be in sporadic increments, depending on incoming US economic data. The most recent NFPs, Advance Retail Sales, and Consumer Confidence reports suggest that only a minor reduction in QE3 is appropriate.
Ultimately, the Yen is at risk for further weakness, but a more dovish Fed – to balance out markets’ hawkish interpretation given bond market dynamics across the global – leaves open the door for a mid- to –late-week rally in the Yen against the US Dollar should US yields take a step backwards this week.
Forecast for Australian Dollar: Bullish
We’ve argued in favor of a significant Australian Dollar recovery since early August. We noted that an improvement in Chinese news-flow will probably help stabilize economic growth expectations for the East Asian giant. China is Australia’s largest trading partner and a critical source of demand for the country’s pivotal mining sector. That meant that stabilization in China was likely to translate into an improved the outlook for Australian exports and the business cycle overall. This in turn would prompt a supportive shift in RBA monetary policy expectations and lay the groundwork for an Aussie recovery. The case for an upside scenario seemed all the more compelling given a backdrop of highly over-extended speculative net-short positioning and we proceeded to enter long AUD/USD after an attractive technical setup presented itself.
A cautious recovery now seems to be underway as expected. However, the week ahead will see the Aussie’s resilience severely tested as the currency takes on high-profile event risk on both the domestic and the global front. Minutes from September’s RBA policy meeting are first to cross the wires. That sit-down produced what the markets interpreted as a shift away from an overtly dovish posture to a neutral one, sending the Australian unit sharply higher and igniting pent-up bullish forces waiting for their cue to overtake momentum. With that in mind, traders will be keenly interested to parse the minutes for confirmation of the tone shift gleaned from the initial policy statement. It is rather rare for RBA meeting minutes to deviate materially from the Governor’s remarks released along with the rate decision. The potential for volatility remains however, and a stray comment that is perceived to amplify or undermine the latest improvement in the Aussie’s policy profile can send the currency higher or lower, respectively.
Thereafter, macro-level forces come into focus as all eyes turn to the Federal Reserve as the policy-setting FOMC committee convenes for its monthly meeting. The outing is expected to produce the first “taper” of the QE3 stimulus program, with the baseline scenario calling for a $10-15 billion cutback in monthly asset purchases. The path forward beyond that remains highly uncertain however. That means the FOMC’s updated set of economic forecasts as well as Chairman Ben Bernanke’s press conference following the policy decision will be surrounded with plenty of speculation and offer ample fodder for volatility. If investors are met with Fed rhetoric that (directly or indirectly) argues in favor of a sustained QE reduction cycle into the end of the year, market-wide risk sentiment is likely to deteriorate and pull the Aussie Dollar downward. A more cautious approach that presents a Fed that still sees stimulus withdrawal as highly data-dependent and injects uncertainty into the near-term policy outlook stands to produce the opposite dynamic.
Source: Dailyfx
