Risk Events Ahead of End of Year Flows

2017 ended, and we can say without a shadow of a doubt that the trend of the previous year was the EURUSD move from almost parity to above the 1.20 level. Like in a game of confirmation, the 1.20 mark came again during the end of year flows.

Such flows are often disregarded by Forex traders. However, this is a big mistake.

One must think of what the price action usually do during holidays. And the whole story starts before holidays…

End of Year Flows

December Trading is Always Tricky

The trading activity during December is always a tricky one. First, there’s barely trading activity at most of the trading desks around the world. There’s only supervision.

Junior traders supervise so there are no mistakes when/if the market moves.

Second, the more time passes in December, the more likely the trading algorithms will squeeze the week retail traders, so it is unlikely that the trends will change.

This is precisely what happened this previous December. The EURUSD squeezed higher and higher and the more the time passed, the closer to the 1.20 it came. Eventually, of course, it broke above.

However, here we are, almost two weeks after, and trading started in the new year. The EURUSD and all the other Euro pairs that followed the same path in the previous month gave back most of the games.

Suddenly, the end of year flows aren’t there anymore, and trading desks start to open one by one. After last week’s NFP numbers, we can say that virtually everyone is up and running.

Squaring Positions

To fully understand the Forex market, one should start from the basics. There are only two directions to take: long or short.

However, any of the direction taken must be squared by the time the trade is closed. This means that if you buy a currency pair and close it in profit or a loss, you’ll end up effectively selling the pair to mark the profit or the loss.

In doing that, you’ll add to the same trend that governed the markets during that period. The move, of course, is more violent, if traders are stopped, rather than when they close a trade to mark a profit.

Conclusion

The main risk during the end of year flows is that traders start the month on the wrong side of the market. Moreover, they live under the impression that the market won’t move, due to the low volatility that is typical for that period.

But, that’s only an impression. Of course, that sharp moves will push prices beyond extremes, and, if you want, there’s no better time to squeeze than holidays time.

Considering all the above, think twice before opening new positions when end of year flows are present.

European Central Bank’s Interest Rate Preview

The most important economic event of the fall comes this Thursday. The European Central Bank (ECB) is poised to change the monetary policy for the Eurozone area, with all eyes on the Euro’s reaction.

It’ll be a landmark decision, as the central bank will alter the bond-buying program further. As always, it’ll do it in such a way to please both hawks and doves.

Almost a year ago, in last December, the ECB started a controversial process: scaling down the bond-buying program. To avoid the taper tantrum caused when the Fed began the same program, the ECB vowed to better-communicate its decisions and to exit the stimulus gradually.

It is no wonder, as the Eurozone economies perform better. Negative rates won’t fit the bill anymore.

With PMI’s (Purchasing Managers Index) pointing to stronger growth in both manufacturing and services sector, and with the unemployment rate looking better and better, the hawks in the Governing Council will try to push for a further stimulus reduction. However, if last December was confusing, expect this decision to be the same.

Current ECB Bond-Buying Program

Under the current program, the ECB buys 60 billion Euro worth of bonds each month. It announced the decision in December 2016 when it created much confusion: while it reduced the program from 80 to 60 billion a month, it extended it for a further nine months. Therefore, the question on everyone’s lips was: is the ECB tapering, or not?

Almost nine months later, this Thursday we should see something similar. The market consensus is for the ECB to reduce the bond-buying program with a further 30 billion/month. That’s tapering!

However, the central bank may pull another stunt and extend the horizon for a further nine months or so. As such, instead of abruptly ending the program, the ECB, while tapering, takes the foot off the gas slowly, not to disturb the markets.

As such, both bulls and bears will have something. The first ones will argue that the ECB reduces the stimulus as now they’ll buy fewer bonds. The other ones will say that fewer for longer is still easing and they’ll sell the Euro.

Long story short, expect the market to be volatile surrounding the press conference.

Euro Ahead of the Event

Euro traded in a range ahead of most of the other currencies for the past month or so. The best one to illustrate this is the EURUSD pair: it stays above 1.17, but below 1.19 for the same period.

Technical traders look for the range to break, with probably pending orders on both sides of the market. Fundamental ones, though, will wait to see the ECB decision. Therefore, it is unlikely that the pair will move much until the release.

The other Euro pairs had a similar trajectory. Ranging seems to be the name of the game, with EURGBP. EURAUD and EURJPY leading the way. Not even Mr. Abe’s re-election wasn’t enough to send the JPY pairs higher.

Conclusion

Expect the Euro pairs to range until Thursday’s event, and to break the ranges shortly afterward. The importance of the ECB communication strategy is obvious via the small ranges the Euro pairs held.

Moving forward, as we get closer to the end of year trading, there’s still time for some critical market moves. Market participants have an eye on the U.S. monetary policy too, so ending on the right side of the market may be a bit trickier this year.

NFP Data in Focus – October 3, 2017

The last quarter of the years started with the U.S. equity markets making new historical highs. It seems that nothing can get stocks down, no matter if the news is geopolitical or comes from the economic area.

NFP Data

Perma-bears seem to be caught on the wrong side of the trade as many leading hedge funds bite the dust. The U.S. equity market rally continues with the Dow Jones printing values North of 22.6K.

The Forex Market and the U.S. Equity Markets

Typically, the currency market considers the moves in the U.S. stock market. Or, it is influenced by them.

That’s especially true when it comes to the USDJPY pair. However, the pair is nowhere near the vertical rise the Dow Jones made lately.

Not even the Fed’s hawkishness is not able to stop investors buying stocks. How come?

When the central bank starts a tightening cycle, the stock market hesitates. In the best-case scenario, the market will consolidate for as long as the tightening cycle continues.

However, not the case this time. There’s an explanation, though.

In their search for higher yields, investors find the U.S. stock market more appealing and safer than other financial markets around the world. Japan called for snap elections, the British and the Eurozone still argue on the Brexit bill, the Northern European countries and Switzerland drown in negative rates…where to put your money as an investor?

Hint: the stock market.

The U.S. Dollar as the World’s Reserve Currency

The same arguments are valid for the U.S. Dollar, though. For currency, the only thing that matters is the interest rate level.

And, the Fed was hawkish at the last FOMC meeting. Even the press conference’s tone was hawkish as well.

Not only that the Fed will raise rates one more time this 2017 (at least that’s the message left), but it’ll start unwinding the massive size of its balance sheet.

That’s unprecedented. Never, in the modern economy, such a thing happened. As such, all other central banks in the world will look and learn how the Fed will handle the situation.

Both actions (the interest rate hike and the balance sheet unwinding) are bullish for the dollar. If we add here the possible tax rate cuts the Trump administration envisions, we have the recipe of a perfect wind for the buck.

Yet, the Forex market is slow to acknowledge these changes. But, it only seems to be a matter of time until the move starts.

NFP Holds Key on the Short-Term

The October NFP is likely to be crucial. Many fear that if data disappoints until December, the Fed will derail the plans to hike the rates.

As such, they’ll look for this Friday’s data to be an indicator of the next rate hike. However, if you think of it, the data shouldn’t matter.

It so happens that the interest rate differential is so big (against the Euro, CHF, JPY, etc.) and rising, that traders have all the incentives to buy the dollar. Sooner or later, it’ll become evident.

Short-term, it could create volatility. However, long-term traders will use any dip in the dollar to establish new long positions.

Conclusion

Look at the end of the year to bring uncertainty in the Forex market. While the U.S. stock market is poised to rip higher still, the dollar will follow only if some of the scenarios presented here will become a reality.

Either Fed will hike the rates, or the tax rate cuts will come sooner rather than later…the dollar bulls only need a reason to push the greenback higher.

Ahead of the FOMC Meeting – September 19, 2017

The Federal Reserve of the United States is about to announce the start of the so-called “quantitative tightening” program. Also known as QT.

It is the exact opposite of the quantitative easing (QE). Under the easing program, the central bank bought U.S. Government bonds. As a consequence, it flooded the financial system with liquidity.

The new program should have the opposite effect. Slowly but surely, it will drain liquidity from the markets.

FOMC Meeting

However, there’s the catch. The Federal Reserve of the United States may be the U.S. central bank. But, when setting the rates on the dollar, it sets the rate for the world’s reserve currency.

The Fed and the Federal Rates

The problem for the rest of the world is that it borrowed massively during the 2008 financial crisis. And, it borrowed in dollars, because the interest rates were down to zero.

Now with the Fed already raising the interest rate to one percent or more, and with the upcoming QT program, the world will experience a dollar shortage.

As such, the dollar should increase in value. That’s the usual effect of a tightening monetary policy. And this one in the United States looks like delivering a double blow to dollar bears.

So far, the markets couldn’t care less. The EURUSD has the 1.20 in view, AUDUSD flirts with 0.8, and the GBPUSD broke 1.36. It even recovered into the Brexit move’s territory.

Monetary Policy Transmission Mechanisms

In a way, this isn’t surprising. The monetary policy transmission mechanisms lag current prices.

The fact that the dollar is so weak is unusual. For the Forex market never expects the actual monetary policy decisions to make their way into the real economy. It’ll act on expectations.

For example, when a central bank becomes dovish and loosens the monetary policy, the currency will react on the spot. Market participants won’t wait for the effects to appear in the real economy. They’ll sell the currency right at the moment the new measures were announced.

What Next for the Rest of the Year?

The world is in limbo. The North Korean showdown puts the JPY on fire, even though it is interesting why the market looks for shelter in a currency that belongs to a country that sees ballistic missiles flying over the population heads. Perhaps the market discounts the North Korean threat.

In any case, the USDJPY looks bullish. If anything, the USDJPY and USDCHF seemed to have been kept at current levels only by the risk off environment lately.

Take that away, and 116, respectively parity are in focus. As for the Euro, the ECB looks to end its quantitative easing program. However, it’ll have a long way until normalizing the monetary policy.

Now that the EURUSD almost broke the 1.21 levels, fewer people favor shorting the common currency. But, if the EURGBP tells us anything, it is not a bullish story.

Conclusion

A higher Euro was the central theme over the summer. It grew against the American dollar and the Great Britain pound, without correcting much. However, summer trading isn’t always relevant for the year. Expect the dollar to fight back, and the current monetary policy differential across the globe might be just the reason for its bounce.

Euro and the ECB

Yesterday’s ECB (European Central Bank) meeting was the main event of the week. All eyes were on Draghi and the monetary policy conditions to be announced.

As such, the Euro was in focus starting with Monday. And, it didn’t disappoint.

For the whole summer, the EURUSD pair moved in an almost vertical line. It rose from 1.05 to 1.20 in less than five months.

Euro

While such moves are not uncommon in the Forex market, they’re not that common for a dollar pair. Many traders tried to fade the move and sold new highs. However, new buyers stepped in on each and every dip.

But why would the EURUSD surge so dramatically?

The Interest Rate Differential

One reason would be the interest rate differential. The only thing is, it should have favored the dollar. Not the Euro.

While the interest rate in the United States rose to 1%, it is still negative in the Eurozone. As such, the interest rate differential should favor the U.S. dollar. Not the Euro.

Yet, the EURUSD pair rose dramatically. The thing is that Forex traders focus on expectations more than on the actual situation.

And, for the whole summer, the signs from the Eurozone economy were positive. Unemployment dropped, GDP (Gross Domestic Product – the total value of goods and services) rose, industrial production as well, PMI’s look good…all signs of a strong and healthy recovery.

Because of that, trader’s expectations grew that the ECB will react. And, that the Fed won’t do anything moving forward.

As such, if the ECB will start tightening the monetary policy (reducing the size of the quantitative easing program), the interest rate differential will shrink. And that’s what drove the Euro higher.

This Week’s ECB Meeting

To many people’s disappointment, the ECB didn’t deliver. Not that traders expected new measures to be announced this week.

But, at least a hint at what’s about to come. Instead, the ECB chose the path of least resistance. Let’s sit and wait and see what will happen.

All bets are now on the October meeting. It is supposed to bring a schedule for the ECB to reduce the bond buying program.

This, alone, is bullish for the Euro. Will send the EURUSD skyrocketing higher. However, only if the Fed won’t change anything. But this is unlikely.

Comes Fed into Discussion

Following the 2008 financial crisis, the Federal Reserve of the United States (Fed), embarked on various monetary policy programs. All destined to ease the monetary conditions.

As a result, the dollar weakened. Moreover, the Fed’s balance sheet increased exponentially.

Now, the Fed started to tighten the monetary policy. It hiked the interest rates four times, lifting it from zero to 1%.

Furthermore, it vowed to start unwinding the balance sheet. Therefore, it will start selling the bonds in its portfolio.

Of course, this will be a gradual process. But, it has a tightening effect on the monetary policy.

Conclusion

No matter how you put it, the Fed seems to be, again, ahead of the curve. While the Euro buyers base their trades on future expectations, dollar bulls look at what happens with the Fed’s actions.

However, there’s one wild card that doesn’t shows up neither in Eurozone nor in the United States. That’s inflation.

If, when and were inflation will pick up first, that’s where the money will flow. Because expectations will grow that the respective central bank will tighten the monetary policy faster. Hence, the cost of money will rise.