Equity price action yesterday displayed investors were hardly bothered by a potential taper from the FOMC this coming Wednesday, as the overnight dip in S&P futures was met with strong buying interest that lifted the index up by 0.63% to finish the day at 1,786. Despite the positive optimism exhibited in equities during yesterday’s session, spot VIX was well in demand over the course of the day, increasing to over 16 vols as traders looked to increase protection ahead of what could be a volatile Fed day tomorrow.
The increase in hedging action that bid up the VIX failed to flow through to the options markets for USDCAD, with Loonie strength depressing implied volatility on the pair as USDCAD pivoted around unchanged for the majority of the day. While there was a slight pick-up in demand for USD calls relative to puts, the 14-day moving average for the 3M 25D risk reversal continues to trend down, signaling calls are becoming relatively cheaper in comparison to puts. We would argue that the divergence between volatility in the equity market compared to the option market for USDCAD presents a potential opportunity for corporates that are naturally short USD and looking to cover off some exposure ahead of the FOMC announcement on Wednesday, as the drop in the price of USD calls will make for relatively more attractive zero-cost hedging structures.
A swath of inflation data hit the wires overnight, with the readings carrying significant economic importance for each respective region. In the UK, while the Bank of England insists medium-term inflation expectations are well anchored, investors were keenly focused on whether or not the sharp drop from 2.7% in September to 2.2% in October could be sustained moving forward, thus giving the BoE a little more confidence in the credibility of their forward guidance. Expectations had been for the y/o/y reading to remain steady at a 2.2% increase over the last 12 months to November, however the official number showed inflation moved closer to the BoE target of 2%, coming in at 2.1% when compared with a year earlier. The softer than expected inflation reading will give the BoE more leeway in communicating its forward guidance of low rates until the 7% unemployment threshold has been achieved, and is putting pressure on the pound this morning as GBPUSD heads back into the mid-1.62s.
On the other end of the spectrum, the European Central Bank would like to see some upward momentum in terms of consumer prices, as concerns of deflation present risks to a balanced recovery throughout the common-currency bloc. The earlier flash reading which saw the headline figure tick up to 0.9% on a y/o/y basis in November was confirmed this morning, but marks the second straight month inflation has remained below the 1.0% level in the zone. The sluggish momentum in consumer prices could be problematic for the zone moving forward, weighing on discretionary spending as consumers choose to hold off on purchases.
The good news for the common-currency bloc was that the economic powerhouse that is Germany continues to do its best to keep the rest of the zone afloat. Economic sentiment for the perceived “back-stop” of the EZ increased to its highest level since April 2006, coming in at 62.0 and blowing the median analyst estimate out of the water. The report from the ZEW institute highlighted that despite the recent string of disappointing data, those surveyed expect further economic development in both Germany and the Eurozone heading into 2014. While we feel there will continue to be challenges in the periphery heading into 2014 (namely a relatively strong EUR at current levels, low inflation, and subdued credit growth), today’s optimism for the path ahead in Germany bodes well for the zone. The EUR is modestly against the big dollar, with traders unwilling to take any outsized directional bets ahead of tomorrow’s Fed meeting.
Also being released this morning were consumer prices for the American economy, and while not the FOMC’s preferred method of tracking inflationary tendencies of the region, the CPI basket will give a good indication for what we may see in PCE inflation in November. Expectations from analysts were that there would be a slight firming in prices from October, with the monthly print forecast to increase by 0.1% while the annual reading hits 1.3%. As it turns out, the headline reading came in flat on a monthly basis, with the y/o/y figure firming less than expected and printing at 1.2%. The restrained inflation data did little to give the USD a boost ahead of tomorrow’s FOMC meeting, highlighting the continuation of asset purchases could be warranted should the Fed want to insure consumer prices head closer towards their long-run target. As a reminder, core PCE inflation only rose by 1.1% in October and may act as a headwind to witnessing a small taper from the Fed on Wednesday, especially if the central tendency forecasts for core PCE are revised lower from the 1.5-1.7% range for 2014 that was estimated at the September FOMC meeting.
S&P futures were slightly steadier after the release, but continue to pivot around UNCH ahead of the opening bell. The Loonie is trying to hold on to its overnight gains with USDCAD putting in work just south of 1.0600, as the CAD garners a slight bid-tone on a strong manufacturing sales print and weaker than expected CPI number from the US.
The inflation data from the US today dovetails nicely into the big event for financial markets this week, with participants intently focused on the Federal’s reserves next indication on the future path of monetary policy. Make sure to discuss a strategy with your dealing teams heading into tomorrow’s release, as this is one of the few meetings were any and all options for the Fed are on the table, with a number of different policy combinations that could potentially make for some choppy and volatile trading conditions. We get the feeling markets are still not quite sure what the optimal level of exposure/protection is heading into the release, and while we still expect the Fed to forego a trimming of asset purchasestomorrow, there is an outside risk that would be justifiable for the Fed to implement a small reduction in the growth of its assets.
What makes tomorrow interesting is that while a small taper would be USD positive and possess negative implications for the majority of other G20 currencies, the impending sting can be somewhat negated should the Fed choose to combine this approach with one that either lengthens its forward guidance due to lower inflation forecasts, or drops its unemployment threshold lower than 6.5%. Alternatively, the imminent rally for high-beta currencies should the Fed choose to keep its asset purchases at the same level could be stymied somewhat if the Fed upgrades its GDP forecasts in response to the budget deal in Washington, essentially guaranteeing we see a taper sometime in Q1 2014. In addition, a cut to interest paid to banks on excess reserves at the Fed is not necessarily off the table forWednesday, and would be USD negative if implemented. That being said, we place the probability of a cut to IOER as the lowest of the aforementioned scenarios, given that it could have the potential to severely distort money market flows before the end of the year. In short, tomorrow’s meeting poses both upside and downside risks for the USD in the near-term, despite our longer-term forecast of a strengthening USD into 2014. Therefore, Wednesday should bring with it adequate trading opportunities from a strategic perspective, and the use of limit orders and trailing stops would some strategies to discuss with your respective dealing teams.
Further reading:
Why the Fed is unlikely to change forward guidance thresholds
US core inflation remains healthy at 1.7% – no hurdle for QE tapering
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