US Dollar Rally Curtailed Ahead of September Fed Meeting - Levels for DXY & USD/JPY
US Dollar Forecast Overview:
- Ahead of time, market participants have entered their typical pre-FOMC drift trading habits, with volatility cooling in the 24-hours leading into the Fed meeting.
- Fed funds are pricing in an 100% chance of a 25-bps rate cut in September and a 78% chance of 50-bps of rate cuts by the end of the year. However, odds of a 50-bps rate cut in September have dropped from over 50% to 13% over the past two weeks.
- Retail trader positioning warns that the current USDJPY price trend may soon reverse higher despite the fact traders remain net-long.
FX markets are gearing up for another important Federal Reserve rate decision on September 18. Ahead of time, market participants have entered their typical pre-FOMC drift trading habits, with volatility cooling in the 24-hours leading into the Fed meeting.
The sense of calm in markets, outside of the random news headline, is effectively the “eye of the storm”: we know that more volatility is coming; it’s a matter of when, not if. And to this end, there have been meaningful shifts in US Treasury yields and the US Dollar (via the DXY Index) as investors get ready to ride out the storm that is the September Fed meeting.
US Treasury Yield Curve Inversion Slowly Abating
With the US-China trade war ina short-term truce, US Treasury yields have been able to recover ground in recent weeks. In fact, the scope and scale of the US Treasury yield rally since the start of September has seen the US yield curve move out of inversion territory at key points; it would stand to reason that near-term US recession odds are dropping as well.
US Treasury Yield Curve: 1-month to 30-years (September 17, 2019) (Chart 1)
While the 2s10s spread has moved in and out of inversion territory in recent weeks, the two key spreads of the US Treasury yield curve – the 3m5s and 3m10s – have been inverted for several weeks now. As a result, US recession odds increased over the summer. But with the US-China trade war in a state of truce as of the start of September, focus is now on the reduced potential for further aggressive monetary stimulus from the Federal Reserve.
The Fed Rate Cut Cycle Not What It Once Was
Fed funds are pricing in an 100% chance of a 25-bps rate cut in September and a 78% chance of 50-bps of rate cuts by the end of the year. However, odds of a 50-bps rate cut in September have dropped from over 50% to 13% over the past two weeks, per Fed funds futures.
Federal Reserve Interest Rate Expectations (September 17, 2019) (Table 1)
Now, Fed funds futures are suggesting that, if there isn’t a 50-bps rate cut in September, then there is a 53% chance of another 25-bps rate cut at the October Fed meeting. Beyond that, there is a 31% chance of another rate cut in December; if not, then markets are favoring January 2020 for another policy move (52% chance).
Eurodollar Contracts Agree with Fed Rates About Cut Cycle
We can measure whether a rate cut is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. Eurodollar contracts continue to be closely aligned with Fed funds regarding the scope and scale of the Fed rate cut cycle.
The chart below showcases the difference in borrowing costs – the spreads – for the continuous front month/January 20 (orange) and the continuous front month/June 20 (blue), in order to gauge where interest rates are headed in the December 2019 Fed meeting and the June 2020 Fed meeting.
Eurodollar Contract Spreads – Continuous Front Month/January 20 (Orange), September 19/January 20 (Green), Continuous Front Month/June 20 (Blue) (March 2019 to September 2019) (Chart 2)
Based on the Eurodollar contract spreads, a 25-bps rate cut is fully discounted at the September Fed meeting. Yet beneath the surface, there have been significant swings in expectations: on September 4, there was a 56% chance of a 50-bps rate cut at the September Fed meeting; now, there is a 0% chance. If there is a 25-bps rate cut at the September Fed meeting, Fed funds are discounting a 56% chance of a final 25-bps rate cut by the end of the year.
DXY PRICE INDEX TECHNICAL ANALYSIS: DAILY CHART (September 2018 to September 2019) (CHART 3)
In our last DXY Index technical forecast update, it was noted that “Even though the yearly high was established on September 3, the DXY Index’s daily candle that day proved to be an inverted hammer/shooting star; a concerning development for bulls. Indeed, price action has been uneven in the ensuing days, with the DXY Index returning to the 61.8% retracement of the 2017 high/2018 low range at 97.87.”
To this end, DXY Index’s topside progress has been minimal, trading at 98.37 at the time this report was written. Momentum continues to deteriorate, with the DXY Index shifting below the daily 8-, 13-, and 21-EMA envelope. Daily MACD continues to trend lower (albeit in bullish territory), while Slow Stochastics have extended their decline into bearish territory. A break of the September low at 97.86 would suggest a more serious near-term topping effort is taking shape.
DXY INDEX PRICE TECHNICAL ANALYSIS: WEEKLY CHART (September 2018 to September 2019) (CHART 4)
The big picture for the US Dollar (via the DXY Index) is potentially troublesome, especially if the triangle’s bullish breakout attempt proves to be a failure after running up to a fresh 2019 high in the first week of September. A recalibration of the trendline support to account for recent price action suggests that the multi-month bearish rising wedge is still in play, leaving open the potential for major downside for the DXY Index.
For the time being, however, if US Treasury yields are able to continue their run higher, then the most sensitive pair to shifts in US yields, USDJPY, will likely remain active. Rising US Treasury yields tend to help USDJPY more than other pairs given that the Bank of Japan keeps its rates held near 0%; USDJPY interest rate differentials are effectively determined by the USD-side of the equation alone.
USDJPY RATE TECHNICAL ANALYSIS: DAILY CHART (September 2018 to September 2019) (CHART 5)
Our most recent USDJPY technical forecast update holds true after little meaningful price action in recent days. “USDJPY has made several significant technical progressions to the topside, breaking the June low and 76.4% retracement of the 2018 to 2019 high/low range near 106.78/97, as well as the descending trendline from the April 24 and July 10 swing highs.”
Having closed above the descending trendline from the April 24 and July 10 swing highs, USDJPY rates have two key resistance bands overhead: the 61.8% retracement of the 2018 to 2019 high/low range near 108.42; and the January 30 swing low at 108.50. A move through 108.42/50 would increase the likelihood that USDJPY rates would return to a 30-pip area around the May 10 swing low and August 1 bearish outside engulfing bar high near 109.02/32. A move below the weekly low at 107.45 would suggest a false breakout has transpired in USDJPY.
IG Client Sentiment Index: USDJPY RATE Forecast (September 17, 2019) (Chart 6)
USDJPY: Retail trader data shows 51.9% of traders are net-long with the ratio of traders long to short at 1.08 to 1. In fact, traders have remained net-long since May 3 when USDJPY traded near 111.62; price has moved 3.1% lower since then. The number of traders net-long is 1.0% higher than yesterday and 13.6% lower from last week, while the number of traders net-short is 11.1% higher than yesterday and 23.6% higher from last week.
We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests USDJPY prices may continue to fall. Yet traders are less net-long than yesterday and compared with last week. Recent changes in sentiment warn that the current USDJPY price trend may soon reverse higher despite the fact traders remain net-long.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
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