The yield playing field

Finally we come to the main event — the ever-rising yield advantage of the dollar over the Euro and yen. The news events associated with this rising relative return are the Federal Open Market Committee (FOMC) meetings — the big Kahuna of events. FOMC meetings marry economic and financial expectations with hard institutional news.

Everyone knows when the Federal Reserve will release its decision, and since it started raising rates in June 2004, the outcome has not been a surprise. All the same, you’d think the Fed’s periodic decisions would deeply influence prices in the forex market.

Alas, you would be wrong. Using data prepared by Stuart Johnston at TimeandTiming.com, forex prices move more on each of the five days leading up to a FOMC meeting than they do afterwards. The Swiss franc, for example, has consistently moved down more often than it has moved up in every five-day, four-day, threeday, two-day and one-day period ahead of the past 62 FOMC meetings. The average move over the five periods is 11.3 points.

On the day of the meeting, and in the one-day, two-day, three-day, fourday, and five-day periods after the 62 meetings, it has also moved down more often than up, but by tiny amounts 3.9 points, on average. Note that in those 62 meetings, the Fed was not always raising rates; on many occasions, it was lowering them.

The same conclusion arises from examination of the data for the Euro, Japanese yen, Canadian dollar, Australian dollar, and Mexican peso. The Japanese yen moves (usually down) by an average of 13.08 points per day on each the five days ahead of meetings and by a mere 4.32 points the day of a meeting and the five days after it. In the Euro, the pre meeting move is 29.4 points per day, and the post-meeting move is 6 points. Of course, the swings are far wider — the average disguises the range — but the principle holds that pre-meeting swings are bigger than post-meeting swings.

This means more than the market anticipates a move and buys on the rumor. It means the rate change OMC event is not “news” because it is not also a shock. This is a testament to the good public relations of the Fed, but at the same time, it deprives traders of what should be a value-laden news item.

The forex market has a preference for big events that are also shocks, whether they are true and useful information or not. Some commentators in the forex market have taken to combining all three sets of factors and weighting them according to “riskiness.” An abrupt rise in the price of oil, for example, raises the level of risk. Risk-averse FOREX market participants would sell dollars on a rise in the overall riskiness of holding dollars, even when sound economic analysis would indicate higher oil prices are no more damaging to the U.S. economy than elsewhere, and maybe less so.

Another case comes from the institutional side of the news. Last February when the Euro was falling, European Central Banks (ECB) President Jean-Claude Trichet warned that the central bank could raise interest rates specifically to protect the Euro from free-fall. The threat carried very little credibility but the Euro spiked upward anyway. Again in October, both Trichet and another ECB policy board member have made the same threat, this time with a little more credibility since inflation is indeed on the rise in Europe, although most money market observers think an actual rate hike is not going to occur until after the new year, if then. And even if the ECB does raise rates, the U.S. will still have a decisive yield advantage (200 or more basis points) over Europe. Still, the possibility of an ECB rate hike raises the riskiness of holding a long dollar positions, so the “news” of a possible European rate hike prompts a dollar sell-off.

But the market has again showed it likes the thrill of uncertainty, and it responded by buying Euros even in the last few days leading up to an FOMC meeting, where the outcome is known. It is perverse to buy the Euro when the next real-life central bank outcome favors the dollar; a sign the market is not operating on hard facts and clear-eyed analysis, but rather thrill-seeking — and using a rise in “risk aversion” to justify it. It’s no wonder the chart sometimes seems to rule the interpretation of serious economic material instead of the other way around.