We use a range of cookies to give you the best possible browsing experience. By continuing to use this website, you agree to our use of cookies.
You can learn more about our cookie policy here, or by following the link at the bottom of any page on our site.

Free Trading Guides
EUR/USD
Mixed
GBP/USD
Bearish
USD/JPY
Bullish
Gold
Bullish
Oil - US Crude
Bullish
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
Bitcoin
Mixed
More View more
Real Time News
  • What are the Market cycles? How are #currencies impacted in these cycles? How can these cycles impact #forextrading patterns? Find out here: https://t.co/ckr2fUOWqW https://t.co/g7iT8bpi7f
  • What are a few of the common trading mistakes made by traders? Find out from @WVenketas here: https://t.co/d3OFc4yGao #tradingstyle https://t.co/wQ1MAkOb0n
  • The UK population voted the Conservative government back in with a strong majority, giving PM Johnson the backing to push Brexit through. And Sterling (GBP) likes it. Get you $GBPUSD market update from @nickcawley1 here: https://t.co/tjCHWDxoWm https://t.co/Z7Vaadxy5r
  • #Gold prices may fall while the US Dollar gains even as economic policies championed by the Trump administration invite inflation. Get your $gld markets news from @IlyaSpivak here:https://t.co/4lHhHsby56 https://t.co/zF4EyLIRWM
  • Lessons from Bretton Woods are forgotten, the US-China #tradewar represents a true existential threat to the post-World War II international trade order, and in turn, the globalized economy that has grown out of the ashes of history. More from @CVecchioFX :https://t.co/paaBxX6Xt0 https://t.co/tcjkQnaBWl
  • What are the truths and myths of #forex trading? Find out from @DailyFX analysts here: https://t.co/uF75VPzstr #FOMOintrading https://t.co/bDXG2dV3wG
  • The US Dollar technical outlook against the Euro, British Pound, Australian Dollar and New Zealand Dollar are discussed. Large wicks left signs of indecision, will reversals follow? $EURUSD $GBPUSD $AUDUSD $NZDUSD - https://www.dailyfx.com/forex/technical/article/fx_technical_weekly/2019/12/15/US-Dollar-Technical-Outlook-EURUSD-GBPUSD-AUDUSD-NZDUSD.html?CHID=9&QPID=917702 https://t.co/dpuIppxo3F
  • What are some trading mistakes @nickcawley1 made during his career and what did he learn from them? Find out: https://t.co/y3cckNW22W https://t.co/vUQyVl6b0e
  • Growth linked currencies have gained as investors hope for progress on the trade front as well as stimulus from the Fed. The global economy however remains depressed and seems likely to remain so. Get your market update from @DavidCottleFX here: https://t.co/jt1HH9AHLM https://t.co/Yz65AMJYlm
  • RT @YuanTalks: #China temporarily suspend additional tariffs of either 10% or 5% on some #US goods scheduled to take effect on Dec 15, said…
Fed Outlook Puts US Dollar and Equities In Troubling Position

Fed Outlook Puts US Dollar and Equities In Troubling Position

2016-02-11 01:09:00
John Kicklighter, Chief Currency Strategist
Share:

Talking Points

  • The FOMC ended seven years of zero rate monetary policy on December 16 with a 25 bp hike
  • Markets project less than a 35 percent probability of a follow up Fed hike in 2016
  • Tempered rate forecasts can hurt the Dollar and potentially forestall an equity market tumble

See the DailyFX Analysts' 1Q forecasts for the Dollar, Euro, Pound, Equities and Gold as well as our favorite 2016 trading opportunities in the DailyFX Trading Guides page.

Fed Chair Janet Yellen testified on monetary policy in her semi-annual (Humphrey-Hawkins) update before a clearly dissatisfied House. A range of topics was covered for the event, but traders were specifically honing in on all the remarks for clues as to how the central bank plans to navigate policy over the coming months. Given the market’s floundering, it was clear that there was no clear consensus on how Yellen’s responses to Congressional questions sets the stage for a more dovish or hawkish path. This is an uncomfortable ambiguity to maintain.

There are many implications born from monetary policy beyond the expected increase or decrease in market based rates. The redistribution of capital through changing speculative views is particularly dramatic now with the US the only major policy group pursuing active tightening while its counterparts are either neutral or proactive with stimulus efforts. These tides can carry different consequences for key market benchmarks. In particular, the Dollar and US equities – which have maintained a positive correlation over the past months – stands to see dramatically divergent responses to next steps from the Fed.

Market Expectations

Before considering the impact that monetary policy can have on the currency and shares, it is important to appreciate how the market’s expectations have developed. Expectations of a return to rate hikes (a ‘hawkish’ regime) have gained considerable traction over the past few years as general FOMC targets for employment were reached and expectations for inflation lifted. That said, outright hawkishness took an abrupt turn around the first quarter of last year.

Fed Outlook Puts US Dollar and Equities In Troubling Position

In the chart above, we find the difference between the market’s and FOMC’s expectations for monetary policy pace. This is specifically the forecast for the benchmark rate through the end of (December) 2016. Both central bank body and average speculator have lowered their forecasts over the past two years; but it is worth nothing that the market has consistently discounted the central bank’s views.

Fed Outlook Puts US Dollar and Equities In Troubling Position

Focusing on the market specifically, the chart above looks at 2-Year Treasury Yields and the implied rate forecast for 12 months forward derived from overnight swaps. Both have fallen dramatically since the first rate hike was secured back on December 16. Despite the FOMC’s official forecast – last updated in the December update – calling for 100 basis points (bp) of hikes through this year, market participants are heavily debating even one standard, 25 bp hike through February of next year. That is a wide contrast.

Fed Outlook Puts US Dollar and Equities In Troubling Position

Naturally, as the outlook for rates sours, the expected pace of hikes from the central bank drop as well. Above we see the implied benchmark rates 2, 3, 6 and 12-months forward through Fed Funds Futures. Where the spread was widening for a year and a half through December/January (though still well below the central bank’s own forecasts), we can see that the outlook has collapsed back towards the current rate.

Monetary Policy and the US Dollar

Rate hikes are a boon for the US Dollar. Expectations for rate hikes, even more so. Rates of return globally are extraordinarily low, so there is little tangible return to be made on carry activity. However, with the expected change in rates, immense capital changes occur. Considering the Federal Reserve is the only major central bank actually tightening the reigns on policy while others actively let out more line, the leverage this disparity has is remarkable.

Fed Outlook Puts US Dollar and Equities In Troubling Position

The US Dollar has certainly absorbed the hawkish implications of both actions and forward guidance from the US central bank and turned it into significant price gains. Yet, this is not a fundamental premium that is permanent or even decisive. As the expectations for tightening whether it be a slower pace through the future, no follow up to the first move in December and certainly a reversal of standing; the currency can lose traction. That is what has happened recently.

Fed Outlook Puts US Dollar and Equities In Troubling Position

Above, we can see the influence of the tempered rate expectations. For Treasury yields, there is a far greater sensitivity to the changing winds. The two-year yield has plunged with the unfolding speculation. The Greenback in turn has not marked as dramatic reversal but it has certainly slowed the ambitious advance it marked in previous years.

Fed Outlook Puts US Dollar and Equities In Troubling Position

A slowed trend can quickly turn into a critical breakdown for technical traders should rate doubts turn into speculative repositioning. Above, we can see the market-implied rate through the end of the year – which has dropped off – compared to the USDollar. Pace has been the key change so far, but clear 12,000 and it may signal a more rapid loss of premium.

Fed Policy and Equities (‘Risk Trends’)

Where higher rates is a boon for a currency as it diverts capital from alternative international investments, it is a considerable risk for domestic capital markets. In the years since the Great Financial Crisis ended, capital has chased higher returns (through capital returns of buying-low-selling-high more than interest/dividends/yield). Key to supporting this optimism tinged with moral hazard whereby investors deemphasized the risk associated to their exposure was the presumption that the Fed and its international counterparts were perpetual stabilizer for the market. Yet, as that support ebbs with rate hikes and talk of balance sheet reductions (that hasn’t started just yet), investors assess a greater personal risk and look to reduce exposure.

Fed Outlook Puts US Dollar and Equities In Troubling Position

One chart to give evidence to the market’s dependency on monetary policy to launch its optimism and exposure is seen above. The S&P 500 is overlaid with the three-month rate of change in the Fed’s balance sheet. As stimulus ballooned with TARP and TALF to QE1, QE2 and QE3; emboldened investors looked to build their portfolios to benefit the period of distorted market strength. Yet, on that same token, when the QE3 program was ‘tapered’ and the central bank leveled out; progress for stocks stalled and grew more volatility.

Fed Outlook Puts US Dollar and Equities In Troubling Position

To aggregate stimulus via balance sheet size with interest rates – which have hit zero long ago – the above chart looks to account for the implications of the two programs together. Using an equivalency calculation the Fed and then Chairman Ben Bernanke offered some years ago, we can see a steady drop into negative territory for the adjusted market rate helped encourage greater exposure. Yet, that support topped and started to turn when the Fed hiked its rates for the first time.

Fed Outlook Puts US Dollar and Equities In Troubling Position

Like the USDollar Index, the S&P 500 is facing serious support on a multi-year basis. Yet, its motivation for a breakdown would fundamentally be different than the currency’s. An easier monetary policy hurts the Dollar but it would theoretically be a boon for the shares market. I say ‘theoretically’ as there is a degree of self-fulfilling prophecy to monetary policy lifting markets. Even a delayed hike may not stop a quick drop in general investor confidence if belief in global monetary policy as a buffer to risk falters.

Fed Outlook Puts US Dollar and Equities In Troubling Position

Looking at speculative positioning, retail trades are on the fence as to whether the SPX500 holds support or breaks through. The level of long and short positions trades off for dominance and in turn leads to flipping net primacy on the Speculative Sentiment Index (SSI). Though it should be noted that both sides of the market are building their exposure quickly as the assumption of a sizable move builds.

See how retail traders are positioning on many assets including key FX pairs, commodities and more on the DailyFX Sentiment page.

Sign up for John’s email distribution list, here.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES

News & Analysis at your fingertips.