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Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

John Kicklighter, Chief Strategist

Dollar, USDJPY, Bitcoin and Dow Talking Points:

  • The FOMC rate decision Wednesday effectively anchored the markets in the lead up to its announcement, while the indefinite hold cheered risk
  • A relief rally in assets like US indices and slip from the Dollar filled the speculative void from the previous few days, but it does little to change the big picture
  • Rising yields and persistent Fed Fund future rate forecasts indicate the top fundamental concern of the past month can still readily take control
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The Fed Delivers a Relief Rally

As was widely expected in the market, the Federal Reserve stuck to their very accommodative policy line this past session when the group announced no change to its mix. In response to the news, there was definitely a jog higher for risk-leaning assets and particularly US equities alongside a pullback from the US Dollar. That is the kind of movement that aligns to a ‘dovish’ response in a market that has grown dependent on extreme accommodation. However, there is a significant difference between a mere relief move from pent up speculation and the genesis of a thematically sustainable trend. I believe thus far, we are facing the former scenario. While the S&P 500 and Dow Jones Industrial Average recovered from bearish gaps lower through Wednesday open to ultimately close at record highs, the lift is neither global nor particularly well founded in the aftermath of the central bank decision.

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Chart of S&P 500 and 100-Day MA Overlaid with Fed Fund Implied Hikes Through 2022 (Daily)

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Chart Created on Tradingview Platform

One of the most consistent features of a market dealing with major event risk is the lead up to the release. The aftermath can be bullish or bearish, market moving or note depending on the outcome relative to expectations. That said, the potential of such an event with the unknown course will naturally curb active and often find market participants balancing risk exposure. Naturally, pre-Fed market conditions registered a pullback on risk assets only to see that slump offset by Asia trade – in other words, a ‘relief rally’. A true commitment to trend insinuates intent founded in a previously unpriced perspective. If global indices (Japan’s Nikkei 225, UK’s FTSE 100, German DAX 30, etc) and other speculatively sensitive assets don’t carry forward the Dow’s enthusiasm, the falter on follow through will likely register quickly.

Chart S&P 500 Overlaid with Aggregate of Fed, ECB, BOE, BOJ, PBOC Balance Sheets (Daily)

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Chart Created by John Kicklighter with Data from Federal Reserve Economic Database and Bloomberg

The Lasting Fed Impact and What Comes After?

While I believe the market’s immediate response to the Fed decision was a knee-jerk reaction that has more to do with the build up the hours before the announcement than actual interpretation of what is ahead, monetary policy is still important. Looking over my scenario table heading into the March FOMC decision, the group managed to toe the line almost perfectly. That said, there is little doubt in my mind that the policy authority recognizes that it cannot promise to maintain such extreme support structures forever. The challenge is how to acclimate a market that has been fed such extreme speculative incentive for years that normalization is inevitable?

Looking back over the past decade, there are a few examples of exactly how this very conundrum was addressed. Previously, the suggestion of change (pulling back on accommodation) was hinted at in low impact speeches from either the Chairman or other members. If the market absorbed the news without panic, more rhetoric to the same effect would follow. The question is when to start this acclimatizing. Wait too long and markets may decide central banks are losing control despite maintaining full support, and then markets could really come off the rails when fear starts to dawn that these safe guards no longer work.

Scenario Table of Federal Reserve Rate Decision

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Chart Created by John Kicklighter with Probabilities from CME’s Fed Fund Futures

As we head into Thursday trade in the Federal Reserve’s wake, I will continue to watch US Treasury yields and Fed Fund futures. There is a history of the market maintaining a deep skepticism over the US central bank’s expectations – whether that is forecast for GDP or intent for its own policy maneuvers. It’s reasonable to suspect that expectations for inflation (which accompanies rising Treasury yields) could very well pressure the Fed to move forward its time table for hikes from after 2023 to something more proximate. I will note that the ‘dot plot’ was already more hawkish this week than it was in the last update in December with four members expecting a hike by 2022 (versus one previously) and seven seeing a hike by 2023 (against 5 previously). In the meantime, mean reverting aspects of the market are starting to absorb the implications of the extended quiet. The VIX Volatility Index for example has slipped distinctly below the historical average at 20 this week, ending a 266 trading day streak above that milestone. It isn’t a systemic shift but carries enough symbolism to perhaps buy a little more breathing room from heavy scrutiny.

Chart of VIX Volatility Index with Historical Average at Approximately 20 (Daily)

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Chart Created on Tradingview Platform

Pairs to Watch for Thursday

Without doubt, the S&P 500 and Dow are two key milestones to keep track of over the next 48 hours. If these benchmarks already pushing record highs are unable to capitalize on the new peak, it will start to draw self-defeating scrutiny. On the FX side of things, USDJPY remains a valuable barometer in the impact of critical catalysts and response. This past session, the pair slipped following the FOMC decision which suggested the Dollar’s tumble was stronger than the risk appetite rally that generally floats most Yen crosses. If the intention is to monitor the knock on effect or even conflicting fundamental themes, this is a very useful measure to gauge whether our fundamental expectations are practical. Furthermore, the Bank of Japan (BOJ) is due to report its own policy updates Friday morning in Tokyo and speculation of a shift in yield curve focus or ETF buying habits have gained serious traction.

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Chart of USDJPY with 200-Week Moving Average and 4-Week Rate of Change (Weekly)

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Chart Created on Tradingview Platform

Another monetary policy event to keep a wary eye on Thursday is the Bank of England (BOE) update due in the London session. While no change is expected, this is the kind of group that has proven to be more active as of late because they don’t have the nearly the international fallout risk that their US counterpart has. For this event, EURGBP will be on my radar, but GBPUSD seems a difficult charge between 1.40 and 1.38. In general, the Dollar is a key fixture for anyone keeping a macro eye. The lack of persistent bias of say a Dow means that this benchmark currency is more finely tuned to the complications of the fundamental scene against issues like market-based rate forecast and the market’s acute speculation as a dormant safe haven.

Chart of DXY Dollar Index and 100 DMA with US 10-Year Treasury Yield and 20-Day Correl (Daily)

Dollar and Dow Seek Clear Trends After Fed Volatility Wash

Chart Created on Tradingview Platform

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