Dollar, Emerging Markets and US Equities: Top FOMC Targets for Volatility

S&P 500, VIX, Dollar, GBPUSD, USDCAD and USDBRL Talking Points:

• FOMC rate decision on tap with the Dollar, US indices and global risk markets awaiting the central banks policy decisions

• With the S&P 500 and Dow pushing record highs as the SKEW ‘tail risk’ index hits a record and put-call ratio holds extremes, there is a disproportionate risk

RISK TRENDS HEADING INTO THE FED DECISION

Despite a run of substantial event risk this past session, there wasn‘t much progress to be found for the benchmarks of the financial system. If anything, the US docket’s record high reading from the factory inflation print (PPI) at 6.6 percent year-over-year growth would overshadow the slump in retail sales and refocus the attention on the monetary policy event ahead. While a case for unwinding before such an event could be made, increasing exposure or shifting to another avenue of risk would be a highly irregular move from an already over-leveraged market. While the S&P 500 and Nasdaq 100 eased back slightly Tuesday, they are for all intents and purposes pushing record highs. While we could consider that confidence and/or complacency, I see it as significant exposure should things go wrong and a speculative avalanche begin. Looking at a few indicators that derivatives traders reference: the SKEW (the ‘tail risk’ index) has pushed a record high before the event while the put-call ratio is still trawling extreme lows. These are not high accuracy indicators in and of themselves, but they can highlight when conditions are primed from a potent trigger.

Chart of the S&P 500 ETF Overlaid with 20 and 100-DMA with Volume (Daily)

As you can tell from the way I‘m referencing risk measures, I believe there is greater potential for a severe ’risk aversion‘ move rather than an equivalent spark for enthusiasm. That is not to say that monetary policy can’t urge another leg higher through a channel that has shifted from growth support to outright moral hazard. It absolutely can. However, the scope for markets to continue their climb from a perspective of a tangible discount is severely limited as few would make such an argument. Speculative reach is a global reality, but there are assets that are at a lower altitude than the records of the S&P 500. One such area that is particularly sensitive to both speculative appetite and the largess of the Federal Reserve is emerging markets. As an aggregate measure, the EEM ETF is a useful measure; but there are plenty of regional constituents that can present more appealing options than others.

Chart of the EEM Emerging Market ETF with 20 and 100-DMAs and Volume (Daily)

THE FOMC SCENARIOS: PROBABILITY VERSUS POTENTIAL

I absolutely believe that everything in trading and investing is based on probabilities. That should be non-controversial given that no one knows the future. That said, there are many out there that will approach a view on the market as if it is a certainty that deserves the most optimized trading strategy. When you approach markets in that way, you will find yourself unprepared for different outcomes with either missed opportunities or a scramble without a strategy. When you think in multiple scenarios, it encourages a deeper consideration of ‘potential’. For example, a status quo outcome where the Fed keeps most aspects of extremely accommodative stance intact would generally ‘meet expectations’ and thereby inspire little adjustment to account for the outcome. Alternatively, even modest changes in policy mix and guidance would seem to surprise and could thereby lead to a more significant response from markets. So, what should we be looking for in this event？

Twitter Poll on What Options the FOMC May Pursue

he meeting that we are currently pass through is one of the so-called ‘quarterly’ gatherings whereby the Summary of Economic Projections (SEP) will accompany the standard monetary policy statement and Chairman Powell‘s press conference which was made a regular aspect of all eight meetings not long ago. It is extremely unlikely that the Fed actually changes the range on its benchmark rate (0.00 to 0.25 percent) or its monthly asset purchases ($120 billion in Treasury and ABS) at this meeting. The most tangible shift would come in the form of changes in the forecast for inflation, growth, employment and/or interest rates. Of those components, most market participants will be looking for an alteration in the dot plot that sees more votes of a hike in 2023 (7 in the March plot) and into 2022 (4 from March). A more nuanced, but the critical shift would come should the Fed make the effort to signal taper discussions are underway. There is an expectation that after the taper starts, it would be completed in three quarters and then the first rate hike would come three quarters after that point. What starts it all is the clear signal from the Fed that the mechanism is in motion. Some fear that the market would panic with a taper tantrum on that news, but I contend that the risk of waiting too long and finding the next crisis without establish tools at their disposal to combat the new threat would be a far worse fate. We’ll see how they view their situation.

Chart of FOMC Scenarios

THE CANDIDATES FOR FOMC VOLATILITY

With the different perspectives and components of the event considered, it is important to consider options for different outcomes. As I mentioned above, there are few risk-leaning assets that would stand to have more than a modest relief rally on an exceptionally dovish outcome. Alternatively, there are plenty of prime options to a capsized market starting with the US indices. On the Dollar‘s side, the perception of a bottomless stimulus could undermine the currency’s effort at lift and perhaps favor close peers with significant liquidity. The trade-weighted DXY Dollar Index is close to the floor on a multi-year range around 89.50/25 which would signal the perception of a seismic shift if it were to break.

Chart of DXY Dollar Index with 50 and 100-DMAs, 20-Day ATR and Historical Range (Daily)

Given the Dollar‘s general position, there are more and significant options for a bullish outcome for the Greenback should the market interpret the outcome as favorable. It should be said that the market could still find a bid under the USD even in the event of a status quo outcome, but I would be less encouraged to participate should such a scenario play out. In the event that the taper discussion indeed starts, I will be looking at USDCAD to the upside considering the Canadian currency benefited significantly from the BOC’s own taper action two months ago which could find a reversal off a long-term support in the 1.2000/50 area. Another major with a technical appeal would be GBPUSD on its head-and-shoulders formation while the AUDUSD and NZDUSD are in a position to reverse high perched congestion as their carry appeal would crumble quickly.

Chart USDCAD with 50 and 100-DMAs and 30-Day Historical Range and ATR (Daily)

Chart Created on Tradingview Platform

On the opposite outcome for where a dovish view is unmistakably interpreted from the event, the combination of an undermined Dollar and potential for even a modest relief rally on risk trends can encourage some fundamental combination options. The emerging market currency crosses are particularly interesting. I will be looking at USDBRL in particular given its significant technical standing but also considering there is a Brazilian Central Bank rate decision on tap where economists are expecting an actual hike. I will also keep USDTRY in mind with the Turkish central bank on Thursday (though it is more likely to cut), but USDMXN and USDZAR are liquid options far less conflicting event risk on their dockets.

Chart of USDBRL with 100-Week Moving Average (Weekly)