FX Update: Eyeing the FOMC meeting and yield curve control

I return to work today after a short holiday for one of the first more determined equity market sell-offs in recent memory, and in the US dollar’s case, the most notable rally in some two weeks – which looks less notable once the trouble is taken to look at how far and how persistently the US dollar has dropped over the last two weeks. All market moves eventually yield to two-way action, and the timing for this bit of consolidation makes sense, given tomorrow’s FOMC meeting, which for the first time in a while has the market in a bit more on the edge of its seat.

The pivotal issue at this FOMC meeting is the latest policy guidance, particularly on an eventual yield-curve-control policy, as we discuss with our CIO Steen Jakobsen on this morning’s Saxo Market Call podcast. The basic idea and historical parallels that market observers draw with the post-World War II experience is that the Fed will eventually move to cap yields at the longer end of the curve to prevent real rates from backing up (and eventually, if inflation returns with a vengeance as more and more market participants and even consumers seem to expect, according to the latest surveys, any yield-capping by the Fed would mean increasingly negative real rates, a boon to risk assets and hard assets alike).

It is too early to expect yield-curve control policy now, but how firmly the Fed hints at its implementation (many presume September) may be enough to move the market – or have risk assets and the USD moved so far that we are in a “sell the market, buy the USD” reaction tactically almost no matter what. As for less likely or more explicitly negative market risks from tomorrow’s FOMC meeting, less clear guidance on eventual policy choices or no mention or endorsement yet of yield curve control together with any sense that the Fed thinks it has done enough for now to allow itself the luxury of a bit of wait-and-see could trigger a fairly steep bit of consolidation of recent moves. The least market friendly outcome and probably very low odds, but still worth mentioning, would be any whiff of a mention of discomfort with the degree of speculative frenzy in asset markets and risks from that to financial stability. This is

Chart: USDJPY
Until the beginning of this week, the USD sell-off was accompanied by an even more brutal sell-off in the JPY. Have a look at AUDJPY if the USDJPY chart doesn’t make this clear. After the Friday payrolls data that saw an additional burst higher in long US yields and move lower in the JPY, the latter has clawed its way back aggressively versus the USD. Already, we have a bearish technical reversal on our hands here if the move sticks below 108.00. And if US yields continue lower whether because the Fed announces the intent to focus on controlling yields well out the yield curve or because we have a new and sudden bout of safe haven seeking on our hands, much is at stake for JPY traders. USDJPY is an interesting sell if the Fed moves more aggressively to indicate it will cap yields far out the US yield curve from here, but if the Fed under-delivers on the dovish side and a bout of risk appetite consolidation settles over the markets, both the USD and the JPY could rally across the board.