We usually don't comment on other central bank decisions, but one has to say that the decision the Fed took was appropriate given the position of the U.S. economy... and it was perfectly communicated and flawlessly executed.-ECB President Mario Draghi, January 2016
A technical trader once told me that fundamentals don't drive the markets and using it does not give traders an edge. He further stated that when the price moves in the opposite direction of what's expected, a fundamental analyst will say "it was priced in".
The fact remains that many, if not most new traders, will solely rely on technicals. Similar to all aspects of trading, fundamental analysis can be difficult to comprehend. As a result, it is also difficult to profit from it without a sound understanding.
While there are several aspects of fundamental analysis, the Federal Reserve made one thing very clear at their March meeting. I hope to convey this and how to profit during the Fed tightening cycle. This one piece of information should allow traders to profit that normally do not follow fundamental developments.
To provide a backdrop to the above quote from ECB's Draghi, it was made during a time where he had great difficulty as several of his speeches and press conferences were causing sharp rallies in the euro, exactly the opposite of what he desired. His quote shows admiration for the Fed as they delivered their first rate hike in the prior month without causing much volatility in the markets and without a sharp sustained dollar rise or fall in the equity markets.
What made the December 2015 Fed rate hike execution flawless was the relatively small increase in volatility. This is great for central banks, but not so much for the trader, who relies on volatility to profit.
Subsequent rate increases have been similar regarding volatility.
So where is the fundamental advantage? Let's take a look at the charts to see how the majors evolved around the Fed meeting.
EUR/USD topped on Thursday, February 2nd and bottomed Thursday, March 2nd. During this four-week decline, the pair fell roughly 335 pips.
GBP/USD topped on Thursday, February 2nd and bottomed on Tuesday, March 14th. During this six-week decline, the pair fell roughly 600 pips. However, that the bulk of the decline occurred from February 24th to March 14th which measured about 460 pips.
USD/JPY bottomed Tuesday, February 28th and topped Friday, March 10th and gained roughly 380 pips during this rally.
AUD/USD made a top on Thursday, February 23rd and bottom on Thursday, March 9th. During this two-week decline, the pair fell 250 pips.
NZD/USD made a top on Monday, February 6th and bottom on Thursday, March 9th. During this decline, the pair fell roughly 485 pips. However, the bulk of the decline occurred from February 28th to March 9th when it declined about 350 pips.
USD/CAD bottomed January 31st, although the bulk of gains were from Friday, February 24th to Thursday, March 9th. This rally resulted in a gain of about 480 pips.
In an order to create a simplified view of when broad-based dollar strength impacted the markets, I've created the chart below.
As can be noted, the greenback gained against most of its counterparts from the last week of March to the week ahead of the Fed meeting.
There will be other drivers impacting the currency pair. For example correlations, as in how USD/JPY correlates with the equity markets or the inverse correlation between USD/CAD and oil prices. Also, central bank policies as NZD/USD declined much earlier with the RBNZ much more cautious than expected at their meeting in early February.
EUR/USD, which is the one that most traders focus on, stands out. During the time frame, the dutch elections had impacted the pair and the ECB, in the meeting ahead of the Fed meeting, was more optimistic than before.
As well, this year politics has played a much larger role in the decision-making process of currency evaluation and speculation.
Looking at the large majority nevertheless, it can be seen that the dollar strengthened against most major currencies from February 28th onward while several currencies dropped lower around February 23/24.
The economic calendar during this time shows that several FOMC members spoke during this time period.
The Federal Reserve has a "blackout period" which begins the second Saturday before the FOMC meeting and ends the Thursday that follows the meeting. Here is a link for exact dates.
So where is the edge?
Simply put, the Fed has long advocated their desire to remain data dependent. They once again executed a rate hike in March without causing excess volatility and were able to so by giving the markets a heads up in speeches ahead of the blackout period.
As they were successful in using this method, they will likely continue to use the speeches ahead of the blackout period to signal whether they will raise rates or not at the upcoming meeting. It is a great advantage as it offers the most flexibility and allows them to remain data dependent as long as possible.
It was the speech on February 28th that provided a pretty clear signal that the Federal Reserve was looking to increase interest rates in March. Every speech that followed essentially contained the same rhetoric.
The implication is simple. If the Fed signals they will raise rates in the speeches ahead of the blackout period, the dollar should strengthened.
Now that we've determined when the dollar will rise on speculation of a rate increase, the question remains:
When does the dollar stop to rise?
The FedWatch tool published by the CME Group is useful for this and can be accessed by following this link.
The CME Group provides the probability of a rate hike at a determined meeting as priced in by the futures market. It shows exactly what is and isn't "priced in".
Remember the trader at the beginning of the article that said fundamental analysts use "priced in" as an excuse when the market doesn't move as expected? This tool takes away the confusion.
Ahead of the hawkish Fed speeches that started around February 28th, the FedWatch tool indicated a probability of a March rate hike was around 30% or so. This meant, there was about a 1 in 3 chance of an increase at the next meeting.
When the Fed signaled that they would raise in the week ahead of the blackout period, the markets repriced expectations as they were caught off guard.
When these probabilities reach around 90% or so, it means the anticipated monetary policy action is essentially fully priced.This was the case at the beginning of the week the Fed was scheduled to meet. As there weren't any major new developments that warranted staying long the dollar at the March 15th meeting, the dollar sold off.
In conclusion, there are several drivers impacting the markets but watching these developments can provide an edge.
- The Fed comments ahead of the blackout period will signal the central bank's intentions.
- The CME FedWatch tool illustrates market expectations and provides a good gauge of when appropriate dollar gains (or declines) are priced in.