Is It Time For True Monetary Policy Divergence?

Understanding A Fed Rate Hike Versus ECB Stimulus Hike

Federal Reserve Monetary Policy Divergence May Be Arriving
Federal Reserve Monetary Policy Divergence May Be Arriving.

Fed Rate Hike versus ECB Stimulus Hike

The US dollar is ending the month of October off the highs, but the turnaround from October 15th has caught the attention of many traders. The turnaround in the US dollar led many to wonder if a genuine divergence of monetary policy is increasingly upon us. Earlier this month, the European Central Bank noted that quantitative easing expansion will be under review in the December meeting, which caused the EUR to become the weakest currency among the G10.

On Wednesday, October 28th, the Federal Reserve surprised markets by noting “at its next meeting”, they may raise interest rates.

In other words, many traders were looking for data that fails to surprise to the upside, and they were expecting lower for longer. However, in such a time as this, rather than uniting, the global monetary policy could soon be diverging. Should the Fed stubbornly bring to fruition the possibility of a December hike while the ECB made it clear it will consider a QE expansion the same month, FX Volatility could be unleashed in all its glory? Until December, we can look to seasonal studies and the trends that will arise from suspected disparities from the data.

What Has EURUSD Done Since March?

A sure thing is a scary thing in markets. For the first three months of the year, the QE trade of selling EUR against almost anything and buying the Deutsche Boerse AG German Stock Index or DAX seem to fit the bill.

By March, EURUSD appeared well on its way to parity in the DAX was up 26% on the year. The problem with sure things is that emotions and risky markets are often like a rubber band that will eventually pull back when stretched far enough. The EUR and DAX did just that.

The DAX went from being up 26% for the year in mid-March, to down nearly 25% from the mid-March highs in late September.

Similarly, EURUSD went from 1.0460 on March 13 to begin a five-month climb that culminated on August 24 to 1.1712 with what is now being deemed, ’mini-black Monday’.  However, that does not mean the EUR downside has finished.

On October 28th, EURUSD broke decidedly below 1.10 and nearly broke 1.09. While the moves not been clean, from the August 24th high, EURUSD has fallen by 800 pips.  The aggressive 800 pip drop may be a sign of things to come. Should the Fed decide to raise rates the same month that ECB decides to expand QE, EURUSD longs could easily abandon ship causing a return to and through the March 13th lows.

The Question Is How High & How Fast?

Because the October Fed meeting indicated that Janet Yellen may be ready to hike rates at the last meeting of the year, the first hike would soon be followed by a few questions. First, how many hikes are expected to follow and does the Fed have a target interest rate that they would like to hike to reach their goals? Given the direction of other central banks, any additional hikes could bring aggressive dollars strength into year end and the beginning of 2016.

The Bank of Japan decided to delay expanding their QE program on October 30th failing to deliver another surprise to the market like they did on October 31st, 2014.

Still, a common thread remains the need for the European and Japanese central banks to support their fragile inflationary backdrop with some form of QE. The alignment of accommodating monetary policy out of Japan and Germany with a tightening Federal Reserve could finally be the driver to send EUR/USD well below 1.00 and USDJPY to 130+.