Market gunning for a dovish Fed

Volatility across markets has collapsed, and were it not for Brexit uncertainty, FX vols might be posting record lows. Looking back at the last couple of episodes where implied and realised volatility did manage to dip to these levels and lower, the period of extremely low energy in markets was very short-lived and quickly yielded to spectacular trends.

The two major prior episodes were the early summer of 2007 and the mid-summer of 2014. The first marked the last days of the JPY carry trade and the beginning of an accelerating slide into the global financial crisis. The second was a brief pause in market activity before the market realized that the Federal Reserve tightening regime was going to continue apace when the rest of the world was not prepared for an ongoing crunch in global offshore USD liquidity. The realisation that the European Central Bank would soon be taking policy in the opposite direction – into QE – set up a once-in-a-decade kind of policy divergence that drove EURUSD from 1.35 to 1.05 in just seven months.

This time around, it is tough to discern – at least from a policy perspective – what catalyst could drive a notable trending move in a super-major currency like the euro, US dollar or yen. The market is less fearful of a general deleveraging move like we saw late last year because it assumes the central banks have its back, after the Fed’s quick volte-face in January. The other major factor suppressing volatility is the attention on the US-China trade negotiations and the conviction that China will maintain currency stability as it moves to offset devaluation risk by encouraging capital flows into its country. A Brexit outcome could spark some volatility as well, though of course this will be most likely limited to sterling pairs, and implied volatility even there would like fall quickly there if the news clears away the uncertainty and is positive for sterling.

But let’s bring the focus back to the present, where we have an extraordinarily complacent market staring down this evening’s FOMC meeting and looking for confirmation of its plans to exercise “patience” and for further specifics on the cessation of asset sales. I’m not sure that the potential for a hawkish surprise is particularly high, rather the risk is more prominent that markets are merely over-positioned for a dovish outcome. But let’s run down the basic scenarios: at the hawkish end of the spectrum would be a Fed that only slightly lowers its dot plot forecast to a single rate hike this year and perhaps one next and insists on maintaining credibility on two-way policy potential, while delaying any decision on QT for now. I lean a bit more on the hawkish side of the spectrum, given the extreme complacency, the incredible rise in equities this year and the bounce back in inflation expectations. But the difficulty in this market has been the lack of a persistent directional move in almost anything. And I have low confidence that a hawkish surprise scenario feeds much more than a knee-jerk reaction for a session or two.

Chart: USDCAD

USDCAD made a classic run on technical support to take out stops yesterday as it dipped below 1.3300. The smart rebound will encourage long positions for a go at 1.3500+ if the FOMC proves benign for the US dollar.