The event that the markets have been waiting for is finally upon us. In less than 24 hours, the Federal Open Market Committee will wrap up its two-day meeting and announce the decisions that have been reached. Considering how investors and traders have speculated and positioned ahead of the event, the outcome would seem a foregone conclusion. If this were the case, the market’s reaction to the event would be subdued. However, that is hardly the case. The fact that the greenback tumbled so sharply and risk appetite rallied so aggressively through September and into October is testament to the level of influence this affair can actually have. Now, in the final approach, we further see the signs of a market that is preparing itself for a potential explosion of volatility and perhaps even the beginnings of a new trend. After four weeks of congestion, EURUSD has put in for a last gasp push to alleviate a rare ‘diamond’ technical pattern. What’s more, volume on the December futures euro futures contract has dropped off notably from the active levels of just a few weeks ago. And, though the S&P 500 may still hold its general bullish bias of the past two months; the pace has been more congestion than progress, volume has trended lower as the advance progressed and short interest has shown a parallel advance. The quiet before the storm.
To benchmark the market’s reaction to the FOMC’s rate decision, it is important to first asses the three general outcomes for any event: inline, better-than-expect or weaker-than-expected. The implications of this shift in monetary policy are a little more complicated than judging in such one-dimensional terms; but we will stick with it for simplicity’s sake. So, to begin, we start with the popular consensus for a second stimulus program (expansion of the current facility) to the tune of $100 billion infusions per month over a series of five to six months. Of the three scenarios, the most difficult to project in terms of market reaction is one where the Fed will offer a more expansive stimulus program than expected. This is certainly a possibility given the bias of the market and the fact that the central bank polled Primary Dealers last week (supposedly to establish expectations so as not to miss them and send capital markets into a tail spin). Here, a ‘nuclear option’ of a large one-off figure (like another $2 trillion) or larger monthly injection for an indefinite period would fulfill the scenario. For risk appetite, this could extend risk taking much further than the current market highs; but for the dollar itself, the marginal devaluation of the currency through money supply will quickly diminish. The scenario with the greatest impact potential is an outcome where the Board of Governors offers a much smaller package than what was expected or abstains all together. Most traders are familiar with the adage ‘buy the rumor, sell the news.’ This would be the case here as speculative positioning has adjusted the dollar and sentiment to a level that is consistent with a certain outcome. If that level is not met, trades will be unwound wholesale. And, finally, we have the ‘in-line’ scenario. We know the general consensus; but this does not mean that the market will not react. There is a wide degree of expectations for the outcome of this policy decision. What’s more, considering speculative interests were responsible for leveraging the capital markets and the dollar to their current position; there will be a strong desire to take profit.
As traders, we may become caught up in the volatility of the event; but it is important to remember there is a short-term and long-term reaction to the fundamental development. Short-term, we are playing against speculative benchmarks; but long-term stimulus is a temporary solution and it is exceptionally dubious when other nations are taking the exact opposite tack. And, a short aside as to the nation’s mid-term elections: the preliminary results seem to be pushing the government towards gridlock. Ultimately, the economy will sway policy, not the other way around.
By John Kicklighter