Think Like a Dealer – FOMC Wednesday

The US Federal Reserve prints it’s FOMC statement tomorrow at 2:15pm EST. After the Fed’s last FOMC announcement, we saw the futures markets price in a much higher expectation of the Fed increasing US short term interest rates by the end of 2009. Without going into the mechanics of futures, US Treasuries and the USD, the result of this move by traders caused he USD to weaken. EUR/USD moved higher by approx 10 big figures in the month that followed; USD/JPY dropped approx 6 big figures in the following three weeks.

However, in the last few weeks that increased expectation of higher interest rates has tailed off. Futures markets show a lower level of participants believe that the Fed will increase rates in 2009. We have seen the USD strengthen, or at least halt its losses in the last two weeks. The market is still positioned slightly in the belief that the US Fed will increase rates this year, though we at Back Bay FX do not believe that to be the case. So tomorrow’s announcement by the US Fed will have a lot of traders worried about their position on US short term interest rates, and therefore the USD. Any hints that the Fed is not going to raise interest rates, potentially in the form of commentary about increasing the Fed’s US Treasury debt buyback program, will cause traders caught the wrong way to cover their positions and this will strengthen the USD.

So the largest of dealing desks know that there is a significant number of market participants who are short USD. What would cause the most amount of transactions (read as “revenues to dealing desks”) to take place? A move higher in USD would cause those who are short to cover their shorts and then create a long position for themselves. Any move lower in USD would not create nearly the amount of trading volume that a higher USD move would create. If USD moves lower, then the majority of market participants (who are short USD) can sit back and count their money. Therefore a move lower in USD would be muted compared to the strength of any move higher in USD.

Our playbook for tomorrow is as follows:

1) Flat positions in USD pairs going into the US Fed announcement

2) Look or comments that imply short term interest rates will remain low. Either directly discussing the economy’s lack of growth or discussing an increase in the Fed’s US Treasury bond and note buyback program. If heard, look to buy USD by shorting GBP/USD and EUR/USD

3) Positive comments on the economy will have less of a market moving impact than negative comments on the economy.