A FOMC meeting for the ages?

What will the Fed deliver this week and whatever the Fed delivers, will it be enough for the market to decide that the central bank is getting ahead of the curve or remains behind the curve and far from catching up. The still strong USD despite the pricing in of significant easing at coming meetings and a still flat rate curve suggest that the Fed is behind the curve and that the bar is high for a dovish surprise – on the order of a fifty basis point move this week that no one is expecting – much like the Greenspan move we discuss below. 

We’ll run through some scenarios on what the Fed may do Wednesday and how the market might react – but for now, suffice it say that this week’s FOMC meeting is one of the most anticipated in recent memory and almost can’t avoid sparking significant volatility, possible in either direction, or both directions, for that matter (i.e., a  kneejerk reaction that is quickly faded). Traders should recognise this and reduce leverage accordingly and consider ways to trade outcomes via long volatility trades or have protective hedges in place.

For now, a couple of past examples of how past Fed “first rate cuts for the cycle” played out are worth considering for perspective on how this can play out:

September 18, 2007: The market was increasingly uneasy about the US housing market and had already suffered an ugly >10% correction over the summer. The market was clearly expecting the first cut for the cycle heading into the scheduled FOMC meeting in September, but only a minority were looking for a 50 basis point cut, and Fed Chairman Bernanke over-delivered. The equity market was duly impressed and managed to rally for around a month and even posted an all-time high before rolling over into the most vicious bear market since the Great Depression. The Fed was extremely behind the curve.

January 3, 2001: US short rates were collapsing as the market priced incoming rate cuts from the Greenspan Fed. The economy was clearly hitting the wall and tech stocks had collapsed into the end of the 2000 (the Nasdaq 100 index was off more than 50% from its early 2000 peak heading into 2001.) Fed Chairman Greenspan didn’t wait for the regularly scheduled meeting for the end of January and slashed rates 50 basis points in a completely unanticipated move on January 3. Equity market bears found themselves ensnared in an epic one-day squeeze that saw the Nasdaq 100 close 18% higher from the previous day on January 4. Tech stocks and the broader market managed to piece together a rally for a few weeks, but were already beginning to roll over in early February despite Greenspan adding another 50 basis points of easing at the end-January FOMC meeting. The bear market was in full swing and the Fed was behind the curve.

The US dollar was in a very different spot in these two historical situations – very strong in 2001 and very weak in 2007. In the earlier case, the US dollar was marginally weaker heading into 2001 after a strong 2000, but firmed again and headed to new cycle highs even as Greenspan launched his aggressive cutting regime, only bottoming out “for good” in 2002 – as it remained a safe haven until it was clear that the bear market bottom was in the rear view mirror. In late 2007 and into mid-2008, the USD continued to weaken on the weight of Fed easing and the thinking that the source of weakness was mostly limited to the US housing market and US banks. But once the global contagion was clear, the USD went vertical – somewhat like the 2001-2003 cycle in that it only turned around the time the equity market bottomed out in March of 2009. 

Chart: NZDUSD – weekly 

An interesting setup for NZDUSD this week as after the potential FOMC earthquake on Wednesday, New Zealand reports its Q1 GDP number a few hours later. Note last week’s sell-off bar entirely engulfing the previous week’s rally of consolidation and also note that we have now worked down the final layers of support stretching back over the last five years.