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It was the day before the biggest central bank meeting for years, and all is (fairly) well. Risk is a little lower, where we can see the Nikkei 225, Hang Seng and CSI 300 down 1.0%, 0.8% and 1% respectively.
The ASX 200 is outperforming, with a 0.2% decline. Most have attributed this decline to Trump’s critique of China and its lack of bean buying. We’ve also got the end of month flows underway, but even then, the feel is one of calm and most have prepositioned portfolios ahead of the impending event risk.
China PMI and Aussie Q2 CPI in play
Of course, it’s all about the FOMC meeting, but traders have had to deal with Aussie Q2 CPI and China’s July PMI data through Asia today. The China data is a small risk positive, but only in so much that it wasn’t worse than last month. At this juncture, there has been no impact on markets, and to say these numbers inspire is a stretch. Manufacturing PMI contracted at a slower pace at to 49.7 (vs 49.6 eyed), although, if we look at the sub-components, we saw improvements in new orders, new export orders and output.
The Aussie Q2 CPI came out 30 minutes after the China data, with AUDUSD spiking 25-pips into .6890 and as we can see from the inter-day chart, there seems to be a supply barrier here.
The fact core CPI remained unchanged at 1.6% (vs 1.5% expectations), doesn’t change the view we should get another rate cut this year, but it certainly fails to provide the RBA scope to go twice this year, and we have seen a slight re-pricing in rate cut expectations for 2019. Given the moves, its clear traders went into the data very long Aussie Treasury’s and short AUD into the release.
(Rate cut probability in Australia)
The calm before the storm?
One way I can look at traders anticipated price moves is through FX implied volatility (IV). Take USDJPY one-day IV; this sits at 11.38%, which to put context on this level, 11.38% is the 53 percentile of the 12-month range. So, given we’re talking about an event that so many have talked about for weeks, if not months, it probably seems a tad low.
We can apply this IV into the Black-Scholes model (with other variables) to understand the market sees, with a 68.2% degree of confidence, a 50-pip move on the session (higher or lower) from the current spot price of 108.5. I can increase this confidence factor to 90%, and see the market feels moves will not exceed 70-pips. We can effectively use this as a guide for risk and position sizing.
Levels to watch in USDJPY
I am not one to advocate trading over this sort of event risk; the variance in the playbook is just too diverse that a high probability trade is unclear. However, in G10 FX USDJPY is probably the purest play on the Fed meeting, as it tracks 2- and 5-year US Treasury’s the closest.
With the sort of move expected, it feels like fading rallies into 109.10/20, or buying pullbacks into 108.00/107.90, is the more compelling trade and adopting a mean reversion strategy. Of course, we will be watching gold, US equities and USD pairs more broadly, not to mention EM assets which will be very sensitive to the language.
Maybe the market is wrong with its view that the Fed meeting won’t cause too great a stir, but this is why traders buy volatility. However, it feels as though everyone is positioned for a 25bp cut, and this will be sold as an insurance cut, predominantly to meet the market and to keep the dream alive.
Of course, we may see 50bp, and subsequently, we may see a short, sharp burst of USD selling, with the yield curve steepening, and gold and equities going on a bullish run, but for a sustained reaction the Fed would need to offer insight that they plan to go again.
A more simplistic approach
Don’t underestimate the fact that fed fund futures are pricing in 66bp of cuts by December – so two cuts and a 65% chance of a third. So, at a very simplistic level for the Fed to get ahead of market pricing, they would need to go 50bp, and offer a view they are prepared, if needed, to go again this year. Anything less, will not meet the market.
The disaster situation
Of course, they could leave the fed funds rate unchanged, a fate some 11 of 86 economists (polled by Bloomberg) feel is possible. And, of course, there is logic here given US GDP is growing around trend, consumption is rosy, with the consumer is feeling fairly content. We can even see housing is fine and the labour market is in rude health, and we saw a slight uptick in core PCE, although it’s still too low at 1.6%. However, it’s the supply side which is concerning; it’s the notion that falling business investment is going to feed into hard data, at a time when global trade volumes are looking uninspiring.
The question of whether a 25bp cut actually achieves anything other than meeting market pricing and risk having the market throwing a wobbly should they not go at all has come up a few times today. Personally, I feel the answer is no, and this measure certainly doesn’t feed into Powell’s recent comment that “an ounce of prevention is worth a pound of cure”, where one would argue a 50bp cut is more suited to meet this statement, married with an outlook that gives us a belief we may see another cut in September.
Ex-NY fed president, Bill Dudley, caused a stir overnight, detailing in an op-ed piece (for Bloomberg) that he thinks it’s a one and done and that marries with the view of ex-Fed Chair Yellen.
After the wait, all the hype and speculation, we finally get a chance to hear the aggregated views of the central bank and to see if they are prepared to set policy as the markets have priced. While implied volatility is unsurprisingly elevated, the market is convinced it will hear what it wants to hear…that is no glaring surprises. Let us see.
Chris Weston, Head of Research at Pepperstone.
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