[embedded content]

SPY S&P 500 ETF, Fed, Stimulus, USDJPY and EURAUD Talking Points

  • The Federal Reserve’s monetary policy update is due at 18:00 GMT Wednesday afternoon and the market is fully expecting a taper announcement
  • Speculation around the timing of the US central bank’s first rate hike is where the market reaction is likely to truly factor in
  • While the central bank event is of serious interest for the Dollar and S&P 500, the perception of global monetary policy ‘normalizing’ has been sinking in – and has even started to temper

Risk Trends and Monetary Policy

We seem to finally be at a critical crossroads for the global financial markets as the Federal Reserve deliberates on whether or not to announce the taper of its massive, post-pandemic stimulus program. The consensus among economists and market participants seems to heavily expect the beginning of the $120 billion-per-month infusion, which is the necessary first step before the real tightening begins with rate hikes at a later date. However, the implications don’t seem to be creating much of a strain on the speculative benchmarks most at-risk of the transition. The S&P 500 has led the Dow and Nasdaq 100 to fresh record highs the day before the eventful decision, seemingly discounting the threat this eventuality would imply. That is remarkable given the scale of panic the mere possibility of this change would have caused in previous months and years. Has the market simply decided that this is not a threat the speculative backdrop and that bulls will just carry on? I am dubious of the market’s seemingly self-assurance.

Chart of SPY S&P 500 ETF with 20 and 50-Day SMA, Volume and 20-Day Disparity (Daily)

Chart Created on Tradingview Platform

When it comes to the short-term risks of a first step to walk back from extreme accommodation (also called ‘normalization’), there isn’t much reason for terror. An easing from this over-accommodative stance is a sign of confidence that the economy and financial system are healthy enough to function without external support. What’s more, the bullish momentum has been well established with a dispersion of confidence into different fundamental sources. That said, a short-term overlook of this first move from the world’s largest central bank isn’t the same thing as the shift carrying serious weight for the long-term and for the global market. Stimulus has, perhaps unintentionally, fostered an exaggeration in risk taking over the years. The severe depression in rates of return has forced capital into increasingly risky venues seeking performance that aims to beat a benchmark like the S&P 500 (‘the market’) which are in many ways peak performance. The notional and thematic leverage that this represents is a bloated risk that will eventually come to pass; and this event will start the process – either quickly or slowly.

Chart of the S&P 500 and Aggregate of Major Central Bank Balance Sheets (Monthly)

Chart Created by John Kicklighter with Data from Bloomberg

It will likely take some time for enough of the market to recognize the shift in the global monetary policy regime to signal the top after a 12-year long speculative climb. Whether this realization comes on ‘all of a sudden’ or gradually depends upon the catalysts along the way. That said, there have certainly been significant milestones over the past months in particular. The perspective of global monetary policy has definitely highlighted a growing willingness to throttle back on the boundless support. Beyond the significant rate hikes from the emerging market players like the Brazilian central bank’s 150 bp hike; we have seen the RBNZ tighten, the BOC end its stimulus program, the RBA stop its yield curve control efforts and anticipation build for a number of major central banks to pursue multiple rate hikes over the coming year. The shift is already well under way, but market traction will remain an open question.

Chart of Perception of Major Central Bank Monetary Policy Standing

Table Created by John Kicklighter

The Federal Reserve’s Options and Market Impact

Below is my scenario analysis for the particular monetary policy event. The principal point of action in this particular summit is a heavily anticipated taper. Economists, analysts and market participants seem to be on the same page as to the start of the central bank’s withdrawal from its stimulus effort. That said, if the Fed does not follow through, beware the market reaction. The Dollar would likely drop, even though it didn’t really build up in the anticipation phase; but risk assets (led by the S&P 500) would likely drop in response. With the market comfortably pricing a slow retreat, a decision not to act could easily be construed as fear of an unforeseen problem that speaks to a weak outlook. If the FOMC does move forward as expected, the real speculation will come through speculating the timetable of the first rate hike.

Table of FOMC Scenario Table

Table Created by John Kicklighter

I have pointed out interest rate expectations via Fed Fund futures for some time – and in the past few weeks in particular. There has been a surge in the implied yield forecasts through this hedging product to the point of fully pricing in two, full 25 basis point hikes through 2022. That said, with the short end of the yield curve in retreat across the developed world this past session; we have also seen the forecast dip back below 50bps. Nevertheless, this same market (and swaps) are still showing a healthy speculation (56% here) for the Fed hike to come by the June 15, 2022 policy gathering. That is aggressive and faster than the Fed’s own timetable would allow for. That doesn’t mean it is impossible, but it would entail the central bank changing its message which would likely translate into market movement.

Table of Fed Rate Probabilities

Table from CME’s FedWatch Tool on cmegroup.com

For Dollar reaction, it is not clear to me that there would be a definitive response from the benchmark currency to an official taper announcement. Consider that the swell in rate expectations these past weeks has unfolded while the Greenback has conspicuously held stock still. If I were looking for a Dollar response in the face of a bullish reaction to the hawkish shift, I would look to pairs that contrast distinct bears. EURUSD is a candidate, but USDJPY is my preferred vehicle. The consolidation this pair has developed over the past week following a chart to multi-year highs is tenuous. On the flip side of the same token, if risk aversion is a strong response to the event, we could still see the fallout in this stalled carry trade offer traction to 112 and perhaps even further beyond.

Chart of USDJPY with 20-Day SMA, 5 and 20-Day ATRs (Daily)

Chart Created on Tradingview Platform

It’s Not Just the Fed

While the Federal Reserve rate decision is absolutely the top listing for the coming session, it isn’t the only update that active traders should be monitoring. Thematically, the volatility in equities that happen to overlap the meme stock designation and earnings interest has offered up peak activity in otherwise reticent markets. On the economic docket, service sector activity readings are a theme on the calendar ahead; but it is the ISM’s US update for October that will carry the greatest weight of a one-look measure considering it is a timely update for the largest aggregate economic group in the world. Furthermore, anticipation remains as strong an influence as event risk releases themselves. The Friday NFPs aside, Thursday’s Bank of England (BOE) rate decision carries with it anticipation of an actual rate hike. That makes for some interesting Sterling analysis.

Calendar of Major Macro Event Risk for the Week

Calendar Created by John Kicklighter

While anticipation is a strong influence, I also believe that some of the significant developments that are behind us still have a part to play in market activity. A particularly remarkable shift recently was the Australian Dollar’s slump despite the RBA’s announcing the first step of its own normalizing journey: the end of the YCC. Next would be an end to QE which is expected around February of next year and then the first rate hike which the group is attempting to project out to 2023. The market seems to have priced this shift in to the point of significant Aussie Dollar gains such that the effort to cool market anticipation of hikes has seen the currency give back ground. If interest rate forecasts more broadly have overreached in carry interest (I think it still seriously underappreciated in general risk considerations), then EURAUD is just one cross that has been very one-sided these past four to six weeks.

Chart of EURAUD with 20-Day SMA and 1-Day Rate of Change (Daily)

Chart Created on Tradingview Platform