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US Dollar Looks to Direct Fed-Generated Volatility for Key Breakouts

US Dollar Looks to Direct Fed-Generated Volatility for Key Breakouts

John Kicklighter, Chief Strategist
US_Dollar_Looks_to_Direct_Fed-Generated_Volatility_for_Key_Breakouts_body_Picture_1.png, US Dollar Looks to Direct Fed-Generated Volatility for Key Breakouts

US Dollar Looks to Direct Fed-Generated Volatility for Key Breakouts

Fundamental Forecast for US Dollar: Bullish

  • This is the last full week of trading this year, but the docket offers the most market-moving event: the FOMC decision
  • Though not the consensus expectation, there is enough speculation of a December Taper to keep the markets enthralled
  • The dollar’s path depends heavily on a December vs March Taper? Trade the US Dollar’s via our Mirror Trader currency basket

Like an action movie tagline: it’s a race against time for the dollar to stir volatility before 2014 runs out of liquidity. Our protagonist (or antagonist depending on your view) is the Fed; and this Wednesday’s FOMC rate decision the trial. Coming to you, this holiday season.

Regardless of what currency pair or asset class you are trading; if you are a technical trader, the charts are captivating. There are more than a few mature ranges ready for a significant breakout (USDollar), early reversals in overextended trends (S&P 500), and temporarily waylaid momentum awaiting a spark to continue their drive (USDJPY). It would seem the perfect scenario for market participants with a surplus of trade setups and the catalysts to put them into motion. However, meaningful movement beyond short bouts of volatility is the low probability scenario.

Traders looking for setups over the coming week will essentially be fighting gravity. A liquidity drain into the end of the year due to the holiday period, year-end capital flows, and market closures is about as close as we come to a natural law in the FX market and global financial markets. This week is the last, full trading week of the year as the Christmas holiday will (symbolically) fall exactly a week after the Fed’s policy meeting. That does not give a lot of time for trends to take root, and it will dissuade many from even attempt it.

Though there are few seasonality effects on the FX market, the implications of this downshift in market activity have very clear repercussions. Referring to the S&P 500 as a benchmark for traditional investor sentiment, December historically exhibits the lowest level of volume of any month of the year and it also happens to be the best month for positive return on average (from 1990 to present). The lack of turnover reflects the diminished speculative participation which will sabotage follow through and dull volatility in currencies as with all other assets. Furthermore, the bullish lean for the index speaks to an appetite for yield and prevailing trends that burdens the dollar.

A simple question: can the Federal Open Market Committee (FOMC) rate decision setoff large moves? Yes. But, the follow through is likely to be limited to the current week, and a sizable run requires we realize perhaps the lowest probability outcome. In the past month, we have seen the market significantly increase the speculation surrounding a January or December Taper (a reduction in the steady $85 billion-per-month stimulus program). Since the central bank’s surprise decision to postpone the downsizing of QE3 and the partial US Government shutdown; we have seen data steadily improve, other monetary groups warm to fresh stimulus, and the Fed maintain a distinctly hawkish attitude towards its forecasts.

This certainly moves forward the probability of a tightening from March or after to March of before. A December Taper would certainly be a bold move for a timid Fed. Nevertheless, there is enough concern of such a move, that a move can be made that we can see volatility generated from a ‘surprise’ one way or the other. Yet, if we recall the September event; there was a buildup in the S&P 500 and drop in the dollar leading into what was a heavily expected taper outcome. Is the market perhaps already prepared for the US central bank to ease back on the accelerator? The litmus test for dollar volatility – much less a dollar rally – is whether risk trends fold under the pressure of a reality of a limited support system from the Fed.

Should the Fed decide to take the easy route and defer, the situation is not exactly settled. In addition to the regular statement that accompanies this event, we are due the quarterly economic forecasts and final press conference from Fed Chairman Ben Bernanke (he retires at the end of January). Though he would not want steer the ship towards rocks just before handing over the helm, the lean towards moderation in moral hazard has been a board effort for some time. With the forecasts, commentary and data (CPI, TICs, housing) due in the week; there is plenty to set up a more active January. - JK

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