Tomorrow's FOMC decision is the dominant topic for investors and traders across all asset classes, with FX, perhaps, the most sensitive to perceived changes (and instigator of trades via carry). As Credit Suisse details, FX volatility remains notably elevated and along with the uncertain flows surrounding so-called "risk parity" trading strategies, and the fact that 2y Treasury yields at around 0.80% are at their highest levels since 2011 - despite the less than 30% chance of a Fed hike priced in for tomorrow - only adds to the sense of uncertainty about the Fed's reaction function. In this light, how do we see the various possibilities that could emerge from tomorrow's FOMC? Here are Credit Suisse's 5 scenarios...
As Exhibit 2 shows, short term FX implied volatility is at elevated levels, with curves typically inverted between the 1-week and 2-week tenors.
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Even beyond the immediacy of this Fed decision, the high likelihood that the Fed will still hike in 2015 even if it passes on doing so this week is contributing to levels of 3m implied volatility being near the highs of the year. As a result implied volatility curves are also inverted further out, for example between the 3m and 1y tenors (see Exhibit 3).
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An obvious contributory factor this elevated level of tension has been more general risk aversion and volatility in wider asset markets. Since June the market has had to contend with a variety of problems ranging from collapsing commodity prices to Chinese equities plunging to pressure on EM space and tremendous FX reserve declines to fears of poor performance for so-called "risk parity" trading strategies.
As Exhibit 4 shows, this has led not only to the more obvious price moves but also to highly unusual ones such as a sharp decline in US swap spreads (linked to the idea that bond holders such as risk-parity investors and EM central banks are offloading Treasuries).
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Such developments only deepen the sense that new and confusing forces are plaguing markets, raising the required risk premium for providing FX liquidity and by implication adding to implied volatility premia.
As for the Fed meeting, the market is pricing in around a 30% chance of a rate hike at this stage. But it still expects to see a rate hike come through by December. Our economists also believe domestic US data momentum is positive enough to compel the Fed to hike this year and think the only strong argument against doing so is the overseas environment and recent related volatility in asset markets globally. As touched on above, the fact that 2y Treasury yields at around 0.80% are at their highest levels since 2011 - despite the less than 50% chance of a Fed hike priced in for tomorrow - only adds to the sense of uncertainty about the Fed's reaction function.
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As Exhibits 6 - 7 show, despite the prevailing impression of extreme USD strength, all that has happened in the past 12 months is that the USD has moved back towards what might be considered fair value from the extremely undervalued levels last seen 12 months ago. And since the 18 March FOMC, which saw the Fed's future interest rate projections considerably lowered, the Fed's broad trade-weighted USD index has failed to make significant ground despite the collapse in many EM currencies. EUR and JPY have proved stubborn since then, while even CNY has seen only a marginal move lower (so far) despite the noise caused by last month's devaluation.
In this light, how do we see the various possibilities that could emerge from tomorrow's FOMC? Here we consider 5 scenarios:
1. A surprisingly hawkish Fed: We define this as a rate hike combined with no downgrade of future terminal rate projections. In this case we would expect the USD to resume trend appreciation and rally by at least 5% by the end of the year on a broad TWI basis.
2. The Fed hikes but qualifies this by producing suppressed terminal rate expectations among other caveats: This should allow the USD to gain ground in line with our existing relatively muted forecast profile for the next 3 months. But the upside move is likely to be short and sharp as the subsequent period of suppressed rate expectations will reduce the potential for rate-differential and by extension FX volatility and trends.
3. The Fed does not hike but makes it clear there is a high chance of a hike this year, while keeping its terminal rate expectations similar to current projections: We would expect a similar reaction to Scenario #2 above. But to the extent that the market can continue to hope for a protracted Fed hiking cycle and material monetary policy divergences persisting with other countries, there may be more lasting opportunities to establish USD longs than the case with Scenario #2.
4. The Fed does not hike, it makes it clear there is a high chance of a hike this year, but still lowers its terminal rate projections: We would a modest USD sell-off of around 2-3% over a period of a couple of 1-2 weeks as the market would wonder if the Fed ever gets into a position to hike rates at all. We would use this as an opportunity to buy USD vs currencies of countries where a policy ease is likely (for example AUD or JPY) or where there are underlying and unsolved fragilities (such as EM currencies like BRL or TRY).
5. A clearly dovish Fed that takes the idea of rate hikes off the table for at least 6 months: This would prove a material shock to the market and should result in material losses for the USD on a TWI basis of at least 5% in the remainder of 2015. This scenario would stress our existing USD-bullish forecast profile unless we were to expect relatively rapid dovish tilts in response by other central banks.
To be clear, as discussed previously, we are not in the camp that sees the start of a Fed hike cycle as signaling the peak of USD strength. While we accept that this was more or less true in the 2004-6 Fed hiking cycle, that was only because conditions outside the US were so good then that other central banks were hiking even more aggressively, and the USD was used as a carry currency. That picture bears little resemblance to current global circumstances.
