If you are looking for a proxy on expectations of from forex traders on what the Fed will at its upcoming FOMC Meeting, you don’t need to look much farther than the USDJPY. After gathering momentum and hitting 79.00 last week, the pair has been in a nosedive since last Friday’s Non Farm Payrolls release. The drop was a result of statements from last month’s FOMC Minutes that the Fed was ready to act if the US economy didn’t improve. These words were then backed up by Fed Chairman Ben Bernanke at Jackson Hole. As such, going into the Non Farm Payroll report, the overwhelming belief was that a poor figure would tip the scales in favor of Fed actions. Therefore, with the NFP missing expectations, forex traders have been shorting the dollar in favor of the yen.
While the drop in the USDJPY seems fair, the force of the move lower reveals that forex traders believe that QE3 is a done deal and further weakness in the pair will occur. As can be seen in the chart below, the USDJPY has broken below its July lows on its current move lower and failed to find much support at 78.20 or 77.85, before finally seeing some demand just above its year lows of 77.60. Therefore, with sellers pushing the USDJPY to six week lows, it seems that these forex traders are shorting on the belief that QE3 will deliver a knockout blow to the pair and a fall below 77.00.
Although a solid case can be made for the Fed activating QE3, they could very well decide to stay on the sidelines. Reasons why that would sense are as follows. First of all, after last month’s FOMC Minutes, Fed members not called Ben Bernanke, went public with their opinion that the market had gone ahead of itself and US economic conditions had improved between the July FOMC Meeting and the time of the Minute’s release. Another reason that they could remain still is that the rest of the world is already out stimulating. As such, stimulus that is being applied in the rest of the world is trickling towards the US. Therefore, after spending hundreds of billions on bailouts and asset purchase programs, the Fed may be inclined to let others do the heavy lifting this time.
USDJPY Reaction
For the USDJPY, this means that the pair is slated to make a big move in either direction. If the Fed does in fact apply QE3, then forex traders have already tipped their hand that they are ready to be aggressive sellers of the pair. On such a scenario, it would most likely cause the USDJPY to drop below 77.00 and from there who knows how much lower. As can be seen in the chart below, beyond our current levels, support disappears until 76.00.
On the other hand, were the Fed to sit tight, and forex traders already getting aggressive with their shorts, it will be expected to trigger a squeeze in the USDJPY. The move higher could also have legs to continue for a while as there may not be another chance for the Fed to act until after the US Presidential elections.
Therefore, for USDJPY traders, it may be best to hold off from taking a position until after the market’s reaction to the news. Such a plan reduces headline risk in the event that the news runs counter to a pre-FOMC positions. Also, with the USDJPY expected to have follow through momentum following the FOMC Meeting, forex traders can still catch the next part of the move.
Gold Reaction
Unlike the USDJPY where the yen has only recently been strengthening against the dollar, priced of gold have been in a steady uptrend since breakout out its long term triangle pattern (see chart). The move has been the result of technical strength (the upper break of the triangle) and fundamental news (global central bank stimulus raises inflation worries). Nonetheless, gold remains well below its record highs. As such, if you had to take a position to be in before the FOMC news, being long gold seems like a viable option. On the one hand, QE3 would lead it higher, and on the other hand, with gold showing relative strength, prices wouldn’t be expected to “spike” lower and a gradual drop would be expected.
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