Forex: Dollar, Risk Trends Ready for Severe Volatility on Fed Decision

Dollar, Risk Trends Ready for Severe Volatility on Fed Decision
Euro Rallies After Greece Completes Bond Buy Back Effort
British Pound: Watch Non-Risk Crosses for UK Jobs Data Impact
Swiss Franc Tumbles after Country’s Largest Bank Introduces Negative Rates
Australian Dollar at High Risk of Post-Fed, Risk Volatility
Japanese Yen: The Positive and Negative of Election Expectations
Gold: Balancing the Risk and Dollar Deflation Aspects of US Stimulus

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Dollar, Risk Trends Ready for Severe Volatility on Fed Decision
The Forex and capital market participants are battening down the hatches for what could be one of the most direct hits of volatility we have seen in a long time. The impending fundamental blast comes via the Federal Reserve’s (Fed) rate decision. Why is this particular policy meeting have the potential market impact? On the surface, this is the quarterly policy decision that carries with it updates on growth, rate and inflation forecasts – an important element to projecting the central bank’s intentions over the medium-term. However, where the real weight in this event lies is the potential of a new stimulus effort. The central bank’s much-discussed Operation Twist program extension expires this month. This scheme of using the funds from selling short-term Treasuries to fund the purchases of longer-dated Treasuries (10 years equivalent or more) has helped to keep the government bond’s yield down, which thereby keeps lending rates low and growth theoretically buoyant.

Given this program’s perceived critical role in fending off a slowdown in economic activity and the general outflow of capital from the financial system, a replacement is highly likely. Of course, before we consider the various scenarios; it is critical to assess the market’s expectations. It isn’t difficult to gauge what the general consensus is when we see that the Dow Jones Industrial Average – among other risk sensitive assets – has run on a more-than-three-week rally. This would suggest that investors have positioned ahead of time for the introduction of a fill-in for the Twist closure. As such, the biggest market reaction we could expect would be for the Fed to allow the program to end and not offer any further supplement to the QE3 effort. The selloff in equities, high-yield currencies and other risk-sensitive assets would be immediate and aggressive. Naturally, an effort that doesn’t increase the money supply and undermines risk taking would be a serious bullish driver for the dollar.

More likely, we will see some replacement. This is where the debate comes in and where the level of impact is less certain. A second extension of Operation Twist would leave 8 months worth of purchases at the $45 billion-per-month rate if they just used government debt. Regardless, it would likely still be seen as a ‘disappointment’ to those that bought into risk. A program of new Treasury purchases is more along the lines of what the market has priced in. An increase of the size of purchases would further whet appetites, but is less likely given they will eventually have to unwind their balance sheet. In the end, even exceeding expectations may not carry risk trends much higher (and drive the dollar down much lower). Looking back to September 13, the introduction of QE3 called the end of US equities bull run and set a V-bottom for USDollar. Furthermore, the end-of-year liquidity drain as well Fiscal Cliff distraction add additional complications to the picture. Expect volatility.

Euro Rallies After Greece Completes Bond Buy Back Effort
The euro showed substantial strength before the gravity of Fed expectations locked the markets down. While there is no doubt a modest carry over from the greenback’s pullback, much of the advance was sourced from the euro itself. From the docket, we would find that the Euro-area’s ZEW investor sentiment survey for December jumped more quickly than expected highest level since April – no doubt as Greece exit risk dissipated. The successful auction of Spanish (12 and 18-month) and Greek (1 and 6-month) bonds would also perk confidence. The biggest boost though would come on news that Greece managed buy €31.8 billion in its bond buyback program. Though at an average of 33.5 percent, that doesn’t hit the target of a debt-to-GDP ratio of 124 percent by 2020 (it is 126.6 percent). Nevertheless, after a teleconference, the Eurogroup remarked that they saw no major issues. Greece will have its aid payout decided Thursday. Today, Banking Supervision is on the agenda.

British Pound: Watch Non-Risk Crosses for UK Jobs Data Impact
For the sterling, any cross that is made with a counterpart at the extremes of the risk spectrum will turn drive the currency to any risk trends driven (or prevented) by the Fed decision. That means pairs like GBPJPY and GBPAUD will struggle. However, for the less exposed (liked GBPCAD), we have some morning event risk to keep tabs on. The November jobless claims are always good for short-term volatility.

Swiss Franc Tumbles after Country’s Largest Bank Introduces Negative Rates
The banking sector is making the progress that the SNB can’t. The top headline for the franc Tuesday was that Switzerland’s biggest bank (UBS) would charge negative rates on franc-based cash deposits. Where the central bank’s 1.2000-EURCHF floor effort fell short is that it didn’t discourage capital from seeking safety in the Swiss banking sector. This does. Is it enough to offset another, sharp risk aversion move though…

Australian Dollar at High Risk of Post-Fed, Risk Volatility
If we want to see where the heaviest reaction to the upcoming volatility from the Fed decision and other big-hitters (Greece aid payout, Fiscal Cliff, etc), we need only look at the highest yielding currency. The Australian dollar is the most prominent investment currency of the majors and therefore presents the most opportunity for activity. AUDUSD and AUDJPY are particularly appealing. And so, the countdown runs.

Japanese Yen: The Positive and Negative of Election Expectations
Recent polls suggest that not only will Shinzo Abe will return as Prime Minister with his LDP party after the election on December 16, but that a partnership will find the two-thirds majority in the lower house of Parliament after the shake up. So, while the focus is still on the threats of active devaluation of the yen; we may also start to see expectations that major reform will be pushed through. That can actually be bullish.

Gold: Balancing the Risk and Dollar Deflation Aspects of US Stimulus
Considering gold plays a number of critical roles in the bigger financial picture, it can be difficult to gain a bead on the metal. Though a safe haven asset, gold would not likely drop very far if a big stimulus effort from the Fed rallied risk appetite trends. Why? Because the dollar would suffer far more, and the commodity is primarily priced in the reserve currency. Ultimately, the ebb and flow of risk trends counts less for gold than an expected increase or decrease in the US money supply on this big event risk.

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