Trying to read the tea leaves in the minutes of a past central bank meeting is sometimes akin to driving while staring in the rear-view mirror. However, with so much hand-wringing going on about the timing of the first Fed rate hike, the minutes of the meetings of the Federal Reserve can provide key insights into likely market behavior. This applies even after a key economic report, like last Friday's jobs report, appears to disrupt the market's existing calculus on the future for rates. Friday's jobs report was weak enough to move Fed futures out further. At the time of writing, Fed Funds futures predicted a 50% chance of a rate hike in October, whereas a month ago, these odds stood at 59.8%.
The most striking feature of the minutes for the mid-March meeting was the Federal Reserve's very mixed feelings toward the timing for the first rate hike:
"Participants expressed a range of views about how they would assess the outlook for inflation and when they might deem it appropriate to begin removing policy accommodation. It was noted that there were no simple criteria for such a judgment, and, in particular, that, in a context of progress toward maximum employment and reasonable confidence that inflation will move back to 2 percent over the medium term, the normalization process could be initiated prior to seeing increases in core price inflation or wage inflation."
There are multiple scenarios in play. I accompany each one with the prediction from the Fed Fund futures.
June rate hike: 6%
"Several participants judged that the economic data and outlook were likely to warrant beginning normalization at the June meeting."
At least one rate hike by July: 15%, Sep: 32%, Oct: 50%, Dec: 61%
"However, others anticipated that the effects of energy price declines and the dollar's appreciation would continue to weigh on inflation in the near term, suggesting that conditions likely would not be appropriate to begin raising rates until later in the year…"
Jan, 2016: 76% (44.7% chance for rate hikes up to at least 0.75%), Mar, 2016: 82% (54.5% chance for rate hikes up to at least 0.75%)
"…and a couple of participants suggested that the economic outlook likely would not call for liftoff until 2016."
The U.S. dollar index continues to maintain a well-defined uptrend
There is a likely irony in all the time and energy spent divining the first rate hike: when it finally happens, the event seems likely to be very anti-climactic. Even though current Fed thinking indicates the market will not receive advanced warning of that first rate hike (in these minutes, the Fed seems to clarify a meeting-by-meeting approach), policy divergence with so many other major economies means the currency market has already spent a lot of time pricing in a tightening of policy. The week-to-week and month-to-month gyrations in economic data are likely to provide more excitement than the event of a first rate hike.
This likely volatility represents an opportunity. The persistent uptrend in the dollar is at least partially a result of policy divergence. Until that fundamental difference changes, every event that appears to or actually does stretch out the timing of the rate hike is an opportunity to buy weakness in the U.S. dollar (NYSEARCA:UUP). On the other hand, the increasing uncertainty in the timing of the first hike means that the dollar's gains are likely tightly capped, all else being equal.
Also capping the potential for additional appreciation in the U.S. dollar is the identification of the dollar as a disinflationary force in the economy (emphasis mine):
"Further improvement in the labor market, a stabilization of energy prices, and a leveling out of the foreign exchange value of the dollar were all seen as helpful in establishing confidence that inflation would turn up."
In other words, a much stronger dollar from here will at least give some Fed participants pause over the timing of a rate hike. This is a mild warning on the currency that starts to contradict my earlier claim that the Fed, unlike many other major central banks, maintains an expressed deference to the market's wisdom in marking up its currency.
The euro remains under pressure
The euro (NYSEARCA:FXE) is a key component of the dollar index. Its chart is almost the inverse of the U.S. dollar index. Its 50-day moving average defines a persistent downtrend. Moreover, the 1.10 level on EUR/USD continues to present stiff overhead resistance. The opportunity in the euro is still to assume this resistance will hold. However, assuming the U.S. dollar index gains are capped, downside in the euro may also be limited to current lows…again, all else being equal. Even when the 1.10 resistance gives way someday, the channel shown in the chart below is likely to serve as the next trading range until the eurozone economy starts showing notable improvement.
Speculators continue to lean heavily against the euro
The euro promises to be particularly volatile, because speculators remain extremely bearish on the currency. In fact, it is the ONLY major currency included in OANDA's CFTC's Commitments of Traders where speculators have not retreated net positioning toward zero in recent weeks. Indeed, speculators have INCREASED their directional bets against the euro. We have already witnessed the impact of this heavy weight against the euro when counter-trend catalysts sent the euro hurtling upward with rapid force (on an intra-day basis).
The United States Oil ETF is trying to confirm a bottoming process
The opportunity space for the uncertainty on Fed policy normalization even extends to oil, particularly trading oil-related equities like the United States Oil ETF (NYSEARCA:USO). On Monday, USO was able to hold on to its gains despite the dollar's comeback from intra-day lows and an accompanying affirmation of its uptrend. USO extended its gains on Tuesday despite a strong day for the U.S. dollar. Wednesday's sharp reversal demonstrated that such divergences are not likely to last long. USO crumbled back to its 50-day moving average as it lost 5.2% and the dollar index held steady.
Source for charts: FreeStockCharts.com
The EIA's forecast and NYMEX futures suggest that oil has essentially bottomed already
There are a myriad of supply and demand issues that also impact oil, so, of course, it is not sufficient to consider currency impacts. I am just claiming that strong divergences between the U.S. dollar and oil are not likely sustainable until the market dynamics change significantly.
The latest Short-Term Energy Outlook (STEO) report from the U.S. Energy Information Administration (EIA) suggests that dynamics have yet to fundamentally change. In fact, the pending deal with Iran inserts additional downside uncertainty to the price of oil. According to the EIA, putting Iran back into the oil market could create anywhere from a $5-$15/barrel downward pressure on its current forecast for 2016. The current baseline forecast for West Texas Intermediate is shown below - note the implication that oil prices have essentially already bottomed. (For a counterpoint, read about Goldman Sachs's expectation that prices need to go much lower to deliver a peak in production).
Source: U.S. EIA
The EIA expects crude oil stocks to start declining in the next two months or so
I still prefer to wait to see an inventory drawdown before I consider the technical bottom in USO shown above more or less confirmed. According to the EIA, peak inventory levels are coming in another few months.
Source: U.S. EIA
A drawdown on inventory will indicate that demand is finally pressuring existing production. Such pressure will help prop up prices. Until then, I expect oil to remain particularly sensitive to currency movements, and thus, to market expectations on U.S. monetary policy. The divergences between oil and the U.S. dollar should trigger the most immediate trading opportunities. (See "A Race Against Volatility And Bearish Sentiment For The United States Oil ETF" for my description of the prospects for a longer-term trading range for oil and USO).
Be careful out there!
Disclosure: The author is short USO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long USO calls and puts for a net short; in forex, I am net long the U.S. dollar