The ending of bond buying matters and its effects on markets will play out over the next year &ndash...
Trading Today’s FOMC Rate Decision
01/28/2009 9:58 am EST
Time of release: 01/28/2009 19:15 GMT, 14:15 EST
Primary Pair Impacted: EUR/USD
The Federal Reserve lowered the benchmark interest rate to a target range of zero and 0.25% for the first time in its history as they saw "substantial" downside risks for growth, and went on to say that the central bank may keep borrowing costs at the record low "for some time" as the economy faces its longest recession in over a quarter century. The committee said that they will consider "various quantitative measures" in an effort to foster economic activity, and discussed setting near-term price targets in order to anchor the outlook for inflation. The FOMC did not present a growth forecast for 2009, but said that the Fed's "balance sheet would need to be maintained at a high level," as the central bank adopted a zero interest rate policy, and said that they "will employ all available tools" as the MPC maintains their dual mandate to ensure price stability while supporting economic growth.
The FOMC lowered the benchmark rate by 100 bps to 1.00% in October, as the credit markets tightened and the economy slowed further. Indeed, the MPC would cite the impact of the Lehman Bros. failure, declining industrial production, a weakening labor market, and declining consumer spending as reasons for the aggressive easing. Markets were expecting the deep cut, as the frozen credit markets had greatly increased the downside risks to growth. Companies had lost their ability to borrow to meet their cash flow needs, increasing the speculation that they would have to cut overhead in order to free up cash. Additionally, the unwinding of the commodity bubble saw price pressures dissipate, giving the central bank the room to lower rates. The expected easing would spark bullish price action resulting in no trade.
The minutes of the September 16th rate decision showed that the Federal Open Market Committee voted 10-0 to hold the benchmark interest rate steady at 2.00% for their third straight meeting. The board noted that upside price pressures have diminished since the previous meeting, as oil prices continued to pull back from the record high in July, and held a dovish outlook as they highlighted the downside risks for growth. The central bank stated that the MPC may ease policy in the coming months, as mounting turmoil in the financial market continues to pose a threat to the overall economy, and went on to say that the Fed will respond as needed. The commentary suggests that the FOMC will, in fact, deliver a rate cut before the end of the year as fears of a recession intensify.
How to Trade This Event Risk |pagebreak|
As the Federal Reserve adopts a zero interest rate policy (ZIRP), the central bank is widely expected to hold borrowing costs at a record low as the world's largest economy faces its longest recession since the 1930's. A Bloomberg News survey shows that 44 of the 45 economists polled forecast the FOMC to hold the benchmark interest rate between zero and 0.25%, and the comments from the MPC suggest that they will hold the rate close to zero "for some time," as policy makers see "substantial" downside risks for growth. The final GDP reading for the third quarter showed that personal consumption dropped the most in over two decades as private-spending slipped 3.8% from the previous quarter, while market participants expect economic activity to contract 5.5% in the fourth quarter, which would be the largest decline since 1982. Signs of a deepening recession continues to emerge, as retail spending in the US fell for the sixth consecutive month in December, which is the worst slump since records began in 1992, and conditions are likely to get worse as the labor market deteriorates at a record pace.
The economy lost 2.58M jobs in 2008, which was the biggest annual drop in employment since the end of World War II in 1945, which pushed the jobless rate to a 15-year high of 7.2% from a revised reading of 6.8% in November, and the outlook for growth remains bleak as consumers continue to face falling home prices paired with financial uncertainties. Moreover, as the Fed considers "various quantitative measures" in an effort to foster economic activity and maintain the 2% target for inflation, managing monetary policy without the use of the interest rate has made the job extremely complex, and market participants are sure to react to the commentary following the decision for further clues on the long-term objectives held by the MPC. Meanwhile, former Fed board member Frederic Mishkin stated that the "more important part of policy now is managing expectations," and suggested that the FOMC should improve transparency by providing a longer-term outlook for growth and inflation as the central bank takes unprecedented measures to shore up the economy. Nevertheless, as risk trends continue to dictate price action in the forex market, the US dollar should continue to benefit from safe-haven flows as investors remain risk adverse.
Trading the given event risk may not be as clear cut as some of our other trades as the benchmark interest rate holds near zero, so we will base our trade on the growth and inflation outlook held by the central bank. Therefore, if the FOMC raises the outlook for long-term growth, and takes additional steps to anchor the outlook for inflation, we will look for a green, five-minute candle following the commentary to confirm a short trade (long dollar) on two lots of the EUR/USD. We will place our initial stop at the nearby swing high (or reasonable distance considering volatility), and our first target will equal this risk. Our second objective will be based on discretion, and in order to preserve our profits, we will move the stop on the second lot to break even once the first lot reaches its target.
On the other hand, a weakening outlook for the growth paired with increased concerns for deflation is likely to weigh on the US dollar. As a result, if the Fed explicitly states that they will continue to increase their balance sheet and plans to boost the money supply, we will follow the same strategy for a short dollar trade as the long position mentioned above, just in reverse.
By David Song of DailyFX.com
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