I went into the Federal Reserve's latest decision on monetary policy very long the U.S. dollar (UUP). The dollar has taken a sound beating all month as, I presume, traders unwound bets on a premature Fed tightening cycle through bond tapering which would have increased the attraction of the dollar through higher rates. I hedged a bit going long the British pound (FXB). As the dollar surged post-Fed decision, my long dollar bets peeled off one-by-one. Typically, the forex market will gyrate wildly after a Fed decision, allowing bears and bulls of all kinds to liberally play whichever side they choose. I expected after the dollar bets closed out, I could prepare to peel off the hedges. While the pound does seem to be bottoming at the time of writing, I find myself unsure. I find myself more perplexed than usual about the market's overall response to this event.
The Federal Reserve announcement sounded a bit like something former governor Mervyn King might say about the prospects for the Bank of England's bond purchase program:
The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.
I imagine believers in the recent bond-tapering hype will zero in on the non-zero probability that the Fed could end its bond purchases at anytime. I choose to focus on the following:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.
Moreover, in his introductory remarks at the Fed press conference, Fed Chairman Ben Bernanke went to great pains to try to allay market fears about the slowing of the pace of bond purchases and reassure folks on the verge of panic that the Fed is nowhere near tightening policy:
It's also worth noting here that, even if a modest reduction in the pace of asset purchases occurs, we would not be shrinking the Federal Reserve's portfolio of securities but only slowing the pace at which we are adding to the portfolio, while continuing to reinvest principal payments and proceeds from maturing holdings as well. These large and growing holdings will continue to put downward pressure on longer-term interest rates. To use the analogy of driving an automobile, any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes.
In other words, the Fed has absolutely no interest in squelching a nascent recovery by responding with an immediate tightening in monetary policy. This has been the case since the Fed outlined its plan for one day normalizing monetary policy; it is the case, and it will continue to be the case. My interpretation of the Fed's interest in accomodative policy is what keeps me locked into keeping gold (GLD) and silver (SLV) in the portfolio.
Of course, my interpretation is secondary to the market's interpretation. After all, the Fed did also suggest that downside risks are lower now: "The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall." However, the Reserve Bank of Australia (RBA) taught me that the assessment of a reduction in downside risks is not the equivalent of a bias for tightening or even an imminent tightening. While I suspect by a week from now, or maybe more, the market will reverse almost every move made in the wake of the Fed decision (and thus begin to re-establish trading ranges in key currency pairs), I think it is informative to run down the winners and losers in the Fed's wake. It may prove useful in future scenarios that strike me as similar.
The U.S. Dollar
Clear winner. From this point forward, the pace of the dollar's recent decline should significantly slow if not end altogether. It appears to me that the dollar is carving out a very extended trading range between its QE2 and QE3 reference levels. These levels represent the trading levels for the U.S. dollar the day before the Fed made these these respective implementations of quantitative easing were on the way.
A sharp post-fed bounce for the U.S. dollar keeps the index well within the QE2/QE3 trading range
Like everyone else, I will continue to watch interest rates. Any reduction in the economy's downside risks can materially drive rates higher given the amount of fear that can packed into lower bond yields. The Federal Reserve's manipulation of rates makes it more difficult to rely on bonds for any reliable signals. But it is notable when rates continue to climb even as the Fed ostensibly fights to keep them low. The iShares Barclays 20-Year Treasury Bond Fund (TLT) cracked a fresh 14-month low (lower prices, higher yields). A continuation of this move should have increasingly broad implications for many trades depending on low rates.
Bonds continue taking a hit
Australian dollar (FXA)
A clear LOSER. The Australian dollar declined against every major currency. The 2% decline in AUD/USD at the time of writing completely wiped out any signal I thought was building for a bottom. The Aussie looks like it could be well on its way to a retest of the 2010 lows above 0.80. This fresh breakdown as a response to the Fed meeting meeting confuses me the most of all the major currency moves since there is nothing in the Fed statement to suggest that the Australian dollar should be the most in trouble: for example, no expectation for a global slowdown that would apply any further pressure on the Australian economy and increase the intensity of the Reserve Bank of Australia's rate-cutting campaign. This is a case where I will not fight the market and assume weakness will beget weakness will reinforce a trend.
A fresh breakdown for the Australian dollar…
2 1/2 months of pound strength against the Australian dollar now seems to be shifting into a higher gear
Japanese yen (FXY)
Neutral. While the U.S. dollar gained on the Japanese yen (validating my assumption that the 94 level on USD/JPY represented a fresh buying opportunity), the yen was mainly flat against the euro and the pound. It of course gained further ground on the Australian dollar.
I continue to assume sharp market reactions will generate opposite trading biases in the dollar versus the yen, that is, immediate weakness in one will translate into immediate strength in the other…like a seesaw. Another run toward 100 for USD/JPY is my most optimistic projection for the immediate term.
USD/JPY may finally have bottomed for now
Mild loser. I am still bullish on the British pound, and I am looking forward to increasing my position on the current weakness in GBP/USD. The current weakness seemed to start after the UK reported CPI numbers Tuesday morning that were ever so slightly higher than expectations. Typically, the pound seems to have strengthened on such news since it augurs for a cessation in the Bank of England's QE. So, I was left a bit confused by this move. For now, I am treating all this weakness as a buying opportunity, a mild pullback after an impressive run off the bottom. EUR/GBP increased slightly post-Fed.
My bullishness on the British pound will get a long overdue test now….
Like the pound, the euro had been gaining ground rapidly on the U.S. dollar going into the Fed meeting. The euro of course lost in the wake of the surging dollar. My main question is why the euro was so strong in the first place. An unwind of carry trades could make sense, but I cannot imagine the second half recovery scenario for the eurozone will unfold starting with a (relatively) strong euro. I am very bearish on the euro at these levels.
Worsening unemployment in the eurozone has not stopped the euro from rallying strongly off the recent bottom
Canadian dollar (FXC)
Mild loser. I remain bearish on the Canadian dollar, but I did not go into the Fed meeting long USD/CAD. I am looking to re-establish a trading position on the next dip in the pair. The main thing to say here is that the immediate-term trend still points upward.
The trend is choppy, but it remains up…
Source for charts: FreeStockCharts.com
While the post-Fed action generated some dramatic reactions, I do not expect the follow-up to stay dramatic. Trading ranges will re-establish themselves in due time. The biggest exception appears to be the Australian dollar which looks set for extended weakness against all currencies.
Additional disclosure: Short TLT through puts and TBT; In forex, I am long GBP/USD (increasing position), short EUR/JPY (will close soon), net neutral Australian dollar (looking to ramp up bearish bet on next signs of weakness). Many trades are taken opportunistically and tend to be short-term.