How to Trade the Fed Rate Decision

The FOMC interest rate decision is less than 24 hours away and the currency market is itching for a breakout. FX option volatilities are nearing 4 month lows and whenever they get to such extreme levels, a sharp expansion in volatility is usually right around the corner. USD/JPY for example has been fluctuating within a slightly more than 100 pip trading range since last Thursday while the EUR/USD has been trading within a 200 pip range. The Federal Reserve interest rate decision is one of the most market moving events in the currency market and given the recent contraction in volatility, we are almost certain that currency traders will not be disappointed by the volatility induced by tomorrow’s announcement. For the first time since August, the Federal Reserve is expected to leave interest rates unchanged. With inflationary pressures continuing to grow they have no choice but to put an end to their 8 month long easing cycle. However their decision tomorrow will not be an easy one because the outlook for growth remains grim. The Conference Board reported today that consumer sentiment fell to the lowest level in 16 years, while house prices dropped by the most on record and manufacturing in the Richmond area slowed to a 4.5 year low (Full FOMC Preview). With this in mind, the Federal Reserve will have a particularly difficult time picking their words for the FOMC statement. There is just as much chance that they will run out with their guns blazing by being unambiguously hawkish as they may try to buy themselves time before the August meeting. The best way to trade the FOMC meeting is reactively, or following the Fed announcement. Given the significance of this meeting and the fact that market is skewed heavily in favor of a rate hike before the end of the year, there should be decent continuation a few hours following the announcement and most likely for remainder of the week. Before the FOMC decision, durable goods orders and a report on new home sales are due for release. Mortgage applications have been on the rise, so there is a decent chance that new home sales could rebound.

Euro: France versus Germany

The Euro strengthened against the US dollar thanks to stronger economic data from France. Even though the near term fate of the EUR/USD will be largely dependent upon the outcome of the FOMC rate decision tomorrow, it is worth noting there is a growing divergence between economic growth in the Eurozone’s two largest member countries. Over the past few weeks, we have had a number of disappointments from Germany including a sharp drop in business confidence and weak retail sales. France on the other hand seems to be chugging along. Consumer spending rose 2 percent last month, more than double the market’s expectations. This has helped to keep business confidence steady even though analysts expect it to fall in the coming months. German and Italian consumer confidence on the other hand did not fare as well. That is probably why ECB member Orphanides was the latest central bank official to say that the market’s expectations for a July rate hike is appropriate but anything beyond July is up in the air. Meanwhile despite a sharp drop in the UBS consumption index, the Swiss Franc has strengthened against the Japanese Yen and Euro.

British Pound Recovers Despite Lack of Data

The UK economic calendar is completely devoid of any market moving data this week other than the final first quarter GDP numbers and the current account balance expected on Friday. Fluctuations in EUR/GBP and the GBP/USD have been kept to a minimum as a result but things should pick tomorrow with the CBI distributive trades report due in the morning and the FOMC rate decision expected in the afternoon. The outlook for the UK economy is still murky. Although no one can forget about the surprisingly strong retail sales numbers on Friday, BBA home loans continue to fall, reflecting the vulnerability of the UK housing market and the overall economy. Earlier this week, Rightmove reported a 1.2 percent drop in house prices this month. The continual erosion in housing market wealth should prevent significant gains in consumer spending in the coming months.

Australian, New Zealand and Canadian Dollars Edge Higher

The Australian, New Zealand and Canadian dollars edged higher today on the heels of a slight drop in the US dollar and modest rise in commodity prices. One of the biggest stories in the world of commodities was China’s agreement to pay nearly double for iron ore. This will have a significant affect on the prices of Chinese goods, which could eventually impact prices globally. No country has managed to escape the global inflation crisis including China. The Australian dollar on the other hand is benefitting from British Gas’ A$13.8 billion hostile bid for Origin Energy Ltd. If this deal goes through, it will most likely include a currency transaction in favor of the Australian dollar.

Yen Crosses Slip on Weak Japanese Economic Outlook

The Japanese Yen lost ground against most of the major currencies, as the Japanese Economic Policy minister said that the country’s business outlook looks grim, due to rising oil prices. In addition, she commented on the uncertain outlook for the second half of the year, as the Japanese economy remains heavily reliant on the US economy. Investors look forward to Merchandize Trade Balance, Small Business Confidence and Corporate Service Prices this evening, in order to gain a better understanding of the business sector’s health. Japan is also expected to follow China in accepting higher iron ore prices, which would add pressure to inflation and growth.

Kathy Lien is the Chief Currency Strategist at FXCM.