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FX Update: Is the Fed policy mistake already in the rear-view mirror?

Forex 4 minutes to read
John Hardy

Head of FX Strategy

Summary:  With the short-squeeze mayhem in Wall Street apparently now helping drive an across the board deleveraging, it is no surprise to see the USD rising sharply, but the JPY sitting out the volatility is another story, especially as long safe haven yields have dropped. Is the USD the only safe haven currency in town? But the key question right now is whether the Fed policy mistake is already in the rear-view mirror.

FX Trading focus: FOMC policy mistake already here?

Yesterday, during the first phase of the Q&A at Fed Chair Powell’s press conference, I tweeted out a couple of compliments on some of the first questions from journalists, who in rough terms asked the Fed whether there was any link between their policies actually causing- or dealing with financial stability risks. This included the very first one from a New York Time correspondent who asked Fed Chair Powell directly if he would comment on the craziness of the GameStop stock moves, which yesterday posted a record USD volume for any US stock ever on a single day, and asked whether the Fed was at all focused on financial stability risks “emanating from the non-bank financial sector…especially search for yield activities”.

Powell answered the question very poorly, as he did a subsequent question along the same lines. The financial stability risks from a market that has lurched into a speculative free-for-all due to excess liquidity and the assumption of an infinite Fed backstop is clearly not a scenario the Fed is prepared for, nor does it have the tools to deal with it. Because if the bubble is already on the loose, so to speak, the only way for it to end is to let it pop of its own accord or to intentionally pop it – and the Fed will be loathe to do that. So it appears it will be up to speculative forces to play themselves out or up to government regulators to make moves on limiting options trading or leverage or flow-selling information or similar to prevent the situation from reaching its own conclusion, which it will do eventually anyway.

Indeed, whether the Fed’s overwhelming liquidity provision had already risked causing destabilizing market volatility was one of my angles on the likelihood that 2021 will prove that the Fed has made and/or will make a policy mistake this year, as I have discussed over the last couple of posts. Yesterday’s market action, in which volatility (VIX) rose by the most in percentage terms ever and the most in points terms since the teeth of the March crisis last year, happened on a day when the S&P 500 index was merely down less than 3%. This fat-tail event points to the premise that the policy mistake is indeed already baked into the cake.

In the FX market reaction to the sudden injection of energy, we witness the usual suspect of USD strength, but very interestingly, no real jump in the JPY, save for against the riskier set of currencies, and that despite solid strength in safe haven sovereign bonds. Very interesting, and suddenly USDJPY is challenging the important 104.50 area again, which would begin to suggest a break above the remarkably well defined and persistent downward sloping channel in place since the summer of last year. The JPY may have changed character quite a bit under the radar as Japanese equities have been a popular play since November and the latest flow of Covid news and shutdowns has  dampened sentiment there.

How does it play out from here? I don’t know, but danger level and the risk of discontinuous moves, even in FX to a degree, is very high. If the market action continues along the same lines for much longer, the Fed will have to eventually move to a stance of keeping markets functioning rather than bailing everything out again, regardless of the level of market pain, as it has already embarrassed itself by underwriting many of market players’ assumptions that have taken us here in the first place. Are markets really ready for a diminishing of the Fed put from here on out? Regardless, I would like to fade USD strength “at some point”, but one has to recognize that if FX markets are also too complacent on volatility risks, that pricing even in  FX can become discontinuous at times as well. Maintaining low leverage, slowly scaling in and keeping plenty of dry powder are the best course of action when volatility is ramping.

The AUDUSD correction is attacking key levels and is one of the higher-energy movers on the spike in market volatility yesterday, also as commodities come under pressure and AUDUSD sits atop many reflationary themes, as I have outlined in the past. The pair is poking around here in the pivotal 0.7600 area that was an area of congestion on the way up. A break of this area could lead to an existential trend-test all the way down in the 0.7400-50 area, below which the setback becomes far greater for the bulls. Treading lightly here for now.

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