Some musings on this week’s volatility ahead of the FOMC

We are rounding off a week where USDJPY rose to a high of 99.30 before crashing to a low of 93.79, the Nikkei fell more than 6% and EURUSD and GBPUSD climbed to their highest level for four months. We will talk more about the events in Emerging markets in our Week Ahead report released later, but needless to say there was carnage in EM FX, which resulted in official intervention in Poland, Turkey, Indonesia, Brazil and India to stem the decline in their currencies.

Our view is that everything right now is rotating around USDJPY. USDJPY looked extremely oversold on a short term basis yesterday, dollar started to look cheap, so a recovery was to be expected. The dollar is higher versus the yen, GBP and EUR today, although, in fairness, moves have been fairly small and volatility has dropped sharply.

Looking ahead the elephant in the room is the FOMC meeting, which concludes next Wednesday. This week’s action was all about pre-empting the Fed’s QE tapering talk and preparing for the worst. Could it be a case of sell the rumour/ buy the fact? It might be. If you believe that the Wall Street Journal has a glass to the wall at the Fed then it said the FOMC’s main aim next week will be about calming the markets, in a report today. If this is right, it could be mildly dollar positive as the market’s potentially price out any aggressive QE tapering from the Fed.

Even if the Fed starts to taper asset purchases this year the global supply of liquidity is still enormous, the BOJ is purchasing the equivalent of $77bn per month and has pledged to do so for 2 years until it doubles its monetary base, which should limit downside in risky assets and USDJPY. We are more sceptical that the ECB and BOE will dive into the QE pool any time soon, hence declines in EURUSD and GBPUSD could be fairly shallow.

In contrast USDJPY could be the big gainer from a little TLC from Bernanke and co. at the FOMC next week. In the short term, the upside seems capped at 96.05 (the high from yesterday), above could see to 96.70 – the 100-day sma, and then 97.50.A soothing FOMC may not see a complete reversal in USDJPY and it may take a while to retrace all of this week’s losses. Markets tend to fall more quickly than they rise, and we don’t expect the bout of volatility we saw last week repeat itself once we have heard from Bernanke himself, unless he surprises the market, which we think is unlikely.

It’s worth noting that central banks in the developed world pride themselves on preparing the markets for their actions so as not to cause excess volatility. The Fed has failed at this as their QE tapering communication has gone awry, causing markets to take a swoon. Bernanke’s chief job next week is to get control of the QE3 conversation and remind markets that the Fed will not do anything too hasty as it exits its massive stimulus programme.

Thus, we could see a return to Goldilocks later next week, neither too hot nor too cold…