U.S. Dollar: How to Trade the Fed Meeting

The U.S. dollar traded higher against every major currency ahead of the Federal Reserve's monetary policy meeting. There are a few reasons why forex traders should be nervous today, but we believe that the rally in the U.S. dollar is a reflection of the market's hope that the Fed will come through tomorrow by growing more hawkish and optimistic. Equities are hovering near their yearly highs along with 2 year bond yields which indicate that the sell-off was not primarily induced by risk aversion. With some Wall Street economists calling for job growth well in excess of 150k, the Federal Reserve is under pressure to act sooner rather than later. However Fed officials do not easily buckle under pressure because they know that once something is telegraphed, it cannot be readily retracted without triggering sharp volatility across the financial markets. The Federal Reserve has not raised interest rates since 2008, but they are in the process of gradually implementing their exit strategy. In our FOMC Preview , we wrote at length about how traders will be paying particular attention to the inclusion or deletion of the phrase "extended period" and to the number of dissenters. One of our readers also made a fantastic point about how the Fed could replace or supplement the Fed funds rate with interest paid on excess bank reserves. In early January, Fed President Lacker had openly suggested allowing more flexibility for the fed funds rate to drift higher while leaving the rate on excess reserves at 0.25 percent. We are not sure the Fed is ready to change their main policy tool but if they do, it should be perceived as a hawkish move.

How to Trade the FOMC Announcement

Meanwhile, we continue to believe that USD/JPY is the best currency pair to use to trade U.S. data because it tends to have the most rational reaction. In other words, hawkishness from the Fed is usually unambiguously positive for USD/JPY while cautiousness should be neutral to bearish. In our FOMC Preview , we talked about how the best way to trade the EUR/USD during the FOMC announcement is to wait for the follow through, which has occurred 8 out of the last 11 times. However the chart also indicates that the initial reaction in the EUR/USD was relatively modest (15 pips in the first 2 hours). USD/JPY on the other hand jumped 40 pips in the hour following the FOMC announcement and a similar type of reaction was seen in December. The difference is that the follow through in USD/JPY over the past few months was a lot shorter and the currency pair even returned to pre FOMC levels the following day. What this suggests is that traders looking for an immediate reaction would prefer USD/JPY while those looking for a slower more gradual move may prefer trading the EUR/USD.

Mixed U.S. Economic Releases

This morning's U.S. economic releases were mixed, but the disappointments should not discourage the Federal Reserve from growing more optimistic. Although manufacturing activity in the NY region slowed, it still expanded for the 8th consecutive month. There was a particularly large jump in key areas such as employees, shipments and new orders. Industrial production increased 0.1 percent which was weaker than the 0.9 percent growth reported in January but stronger than the market's flat forecast. Capacity utilization increased from 72.5 to 72.7 percent in February, a precursor to additional hiring. The only unambiguously weak report was the scaled back demand for dollar denominated assets. According to the Treasury International Capital flow report, foreign demand for long term Treasuries grew $19.1B (against expectations of $47.5B) but due to sales of shorter term Treasury bills, there was a net outflow of $33.4B in January. For the third consecutive month, China was a net seller of U.S. dollars. They continued to buy U.S. notes and bonds but dumped holdings of Treasury bills. China has been openly mulling a more flexible exchange rate and this could part of their grand plan to diversify out of U.S. dollars. Before the Fed meeting, housing starts, building permits and import prices will be released. These report could clarify the outlook for monetary policy.

EUR/USD: EU FINANCE MINISTERS INDECISIVE ON GREECE

The euro sold off against the U.S. dollar partially due to positioning ahead of the FOMC meeting but mostly due to the lack of concrete details on the type of support that EU nations would provide to Greece. Rather than laying out a contingency plan, EU finance ministers continued to bicker about who would be willing to offer assistance to Greece if they were to ask for it. Everyone agrees that the EU rules forbid a bailout, but there is no emergency plan. The options that were floated around include telling Greece to sell bonds guaranteed by euro-region governments or offering loans. Here was an opportunity for EU nations to come up with a concrete contingency plan for Greece but rather than doing so, their actions only highlighted the difficulty of getting such a large number of countries to agree. Also, EU nations spent more time harping of Greece's lack of need which is discouraging because it is not a solution. Meanwhile ECB President Trichet expressed his frustration with the recurrent problems with Greek data which he called "not tolerable." In terms of the Eurozone economy, he believes the euro is not in danger and economic growth is still modest. It will be interesting to see if investors share his same sentiment tomorrow. The German ZEW of investor confidence will be released in the morning and based upon the uptick in manufacturing activity, confidence could improve. The move in the Swiss Franc is also worth noting as EUR/CHF fell to the lowest level in a year. To everyone's surprise, Swiss producer prices fell in February. As this is a consequence of a strong currency, the Swiss National Bank could feel tempted to intervene in its currency but with the global economy stabilizing, the risk of intervention is lower than before.

GBP/USD: MOODY'S TAKES A STAB AT THE POUND

The British pound sold off aggressively today, erasing all of Friday's gains. A report today released by Moody's showed that along with the US, the UK is drifting substantially closer to having its pristine AAA rating cut. This report was meant as a "warning shot", says Moody's on the concern that the country spends a larger percentage of its revenue on debt servicing than what is typically for a triple-A rated country. Even though the report mostly focused on the US, the UK may be in trouble considering a tight race for the elections later this year. A new poll released today showed that the leading parties are basically neck and neck in the race, drastically increasing the odds of a hung and divided parliament come summer. What this means is that any proposal to make more rapid deficit reductions would be subject to paralyzing political battles, probably keeping any significant legislation from going through. On a good note, a report released from the Bank of England expressed budding optimism on the future of the labor market. The BoE finds that they expect "the headcount to remain broadly stable" as employment fared much better than the decline in output during the recession. Of course, there remains "considerable uncertainty" as to the future health of the job market. Rightmove also released their home price report which showed prices increased at the smallest rate on record. We will see more in terms of housing with tomorrow's DCLG House Price Index.

USD/CAD: FLAHERTY PUSHES FRAGILE RECOVERY THEORY

The commodity currency universe is taking a hit today as risk tolerance has dried up on the new credit rating concerns. Losses have been magnified based on crude's nearly 2.0% loss on the day. USD/CAD took on gains for the first time in an unprecedented eleven trading sessions. On a technical basis alone, the loonie was due for a selloff, but Finance Minister Flaherty's comments only managed to worsen the situation. Flaherty continues to preach that, in fact, the Canadian recovery remains fragile. This is not the first time Flaherty has cast doubt in the viability of the country's improvement, and said that because of the inherent uncertainty he would continue to run a deficit in order to preserve stimulus efforts for the next 12 months. However, it is questionable at this point whether the country still needs that backing since its latest string of data has shown signs of economic improvement. In Canada's only release of the day, growth in New Motor Vehicle sales came in flat for this month, down from 2.6% last month. New Zealand produced the only other piece of economic data with its Performance of Services Index. The headline number looked pretty good but concerns lurked behind the shadows in the form of the employment component, which sank to a four month low. The RBA minutes will be released this evening and it will be interesting to see if the central bank telegraphs additional tightening.

USD/JPY: OPTIMISM PERVADES IN JAPAN'S ECONOMY

For the past 3 trading days, the U.S. dollar ended the North American trading session virtually unchanged. Last night, the Japanese government announced that they raised their assessment of the economy for the first time since last July. The government has found that the "economy has been picking up steadily." However, the rosy outlook seems to be a sharp contradiction to recent calls for added stimulus to address an uncontrollable deflationary problem. However, while the committee still noted that the country is in a "mild deflationary phase", other factors are apparently at play. In particular, the export sector continues to drive the economic activity. Nevertheless, as evidence by today's economic data, some domestic problems seem to be easing as well. Household Consumer Confidence rose to highest level in four months. A rise in confidence confirms the latest indication that unemployment is starting to subside and consumer spending is beginning to pick up. Most notably, the index showed that confidence in the job market was the strongest component of the indicator. Nevertheless, the rise to 39.8 in the index still signals deeply entrenched levels. In general, optimists remain the minority until the index exceeds 50.

EUR/USD: Currency in Play for Next 24 Hours

The EUR/USD will be the currency for the next 24 hours. The Euro-zone will release its Consumer Price Index and ZEW Sentiment report at 6:00 am ET or 10:00 GMT. In the U.S. we expect housing starts, building permits and import prices at 8:30 am ET or 12:30 GMT followed by the FOMC Rate Decision at 2:15 pm ET or 18:15 GMT.

EUR/USD continues to tread water in the Bollinger band range trading zone. Volatility remains low and for the time being, gains should be capped at the 1.3800 level, which should act as pretty strong resistance. For support, the closest level of support is the 10-day moving average, which is hovering around 1.3652. The moving average managed to keep losses from earlier contained and helped the euro push off of the lows for the day. Nevertheless the contraction in the EUR/USD begs of a breakout that could be triggered by the FOMC announcement.