Increased volatility in AUD/USD with a rate cut in play

Central banks’ battle to control disinflationary pressures continues in earnest, with the Federal Reserve acknowledging lower inflation expectations. Expectations for a February rate cut in Australia have also dramatically increased.

Source: Bloomberg

To be fair, the Fed statement was quite nuanced and, while inflation ‘declined further’ below the Committee’s longer-term objective, they were more upbeat on the labour market and economy, which is undergoing a more ‘solid’ pace of growth.

The fact the Fed are now paying greater attention to international issues is a new development and really shows they look globally, but act locally. Still, if we look at market pricing, the market has pushed out the view that the Fed will raise rates until November.

This seems about right when every other developed economy’s central bank is easing rates, injecting liquidity or at least moving (like we saw from the Reserve Bank of New Zealand this morning) to a neutral stance.

Good buying in US bonds, selling in equities

What was also interesting was the crazy price action in US markets. Fine, oil has broken to new lows and a number of corporates are either cutting back on capex, curbing capital management initiatives or even portraying a tough operating environment in a rising USD, but traditionally a buying spree in the US bond market (on a dovish message) has been met with good buying in the equity market. This hasn’t materialised and, while rate hike expectations have been pushed back, the bears clearly had the upper hand. Strange times indeed.

The fact is no one knows when a rate hike will occur (it’s data-dependant) and, while the Fed would like to be in a position to raise, the lessons of 1938 still haunt them – raising rates too early caused the second leg of the Great Depression. Next month’s Semi-Annual Federal Reserve policy testimony will be very interesting and could set the scene for an important March FOMC meeting.

Still, while market commentators obsess over when the Fed raises rates, a much more interesting debate is taking place in Australia, centring on when (or if) the Reserve Bank of Australia cuts rates.

Yesterday’s 0.7% quarterly increase to core inflation saw the AUD/USD test the 38.2% retracement of the recent sell-off at $0.8025, but sellers came into the pair. This seems to have coincided with an article from local journalist Terry Mccrann concluding a February rate cut is a done deal. This message seems so out of kilter with views from economists yesterday and ultimately the swaps market have been on a wild ride.

Rarely in a 24 hour period do you see the market price in a 43% chance of a rate cut, then fall to 12% on stronger core inflation numbers and then swing all the way back to 55%, as they currently stand.

Tuesday’s RBA meeting in play

This makes this coming Tuesday’s RBA meeting a ‘live’ one and therefore volatility should be seen in abundance. If we look at options pricing, implied volatility is currently 16.83% (the highest since June 2013), which is what you’d expect when G10 currencies are seeing sizeable intra-day ranges and the rates outcome is effectively  a toss of a coin.

So, to take advantage of elevated volatility I would look at buying a one-week AUD/USD $0.7950 call for 59.7 points and buy an AUD/USD one-week $0.7850 put for 65.3 points. My view is that implied volatility is likely to continue rising and this options strategy (strangle) looks fairly compelling if you just want to take advantage of potential volatility.

The Australian equity market’s anticipation of a pending rate cut has seen solid buying activity from the lows. The bulls seem in control at present and, once again, the idea of waiting until around 10:30 AEDT and then looking to buy has worked quite well. If we look at the market internals, 67% of ASX 200 companies are above their 50-day moving average as things stand. Compare this to the German DAX on 90% and French CAC 40 on 87% and you could make an argument that gains in the local market haven’t been as broad-based as European markets. But they also suggest we can push higher.

US futures have had a modest move higher today, although Japan and China haven’t really helped. On a stock level, we saw strong after-hours activity in Apple, but the earnings batten has now been firmly passed to Google. Recall Google have a fairly poor earnings pedigree, having missed EPS expectations in five of the last eight reports and, certainly if you look at the down trend in the 20-day moving average, the bulls will be hoping to see a new catalyst.

Europe won’t take any heart from the stabilisation in US futures and should see aggressive selling on the open. Greek banks will be in play, but while they have been smashed of late, they are not technically at extreme lows yet. Elsewhere, German inflation is expected to fall, while US jobless claims and December pending homes sales could really throw the spotlight on the current sentiment in the market.

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