FX - EUR/USD: Trading the Federal Open Market Committee Interest Rate Decision

Trading the News: Federal Open Market Committee Interest Rate Decision

Why Is This Event Important:

The Federal Open Market Committee is widely expected to maintain its current policy in January, but comments following the rate decision is likely to spark increased volatility in the exchange rate as investors weigh the prospects for future policy. Fed Chairman Ben Bernanke is likely to maintain a dovish tone while delivering the policy statement, and the central bank may continue to highlight the downside risks for growth and inflation as the current pace of economic expansion remains “insufficient to bring down unemployment.”

What’s Expected:

Time of release:01/26/2011 19:15 GMT, 14:15 EST

Primary Pair Impact :EURUSD

Expected: 0.25%

Previous: 0.25%

DailyFX Forecast: 0.25%

Will This Be Market Moving (Scenarios):

A Bloomberg News survey shows all of the 100 economists polled forecast the Fed to hold the benchmark interest rate between 0-0.25% this month, while the Fed Funds Implied Probability shows a 68% chance for the central bank to maintain its current policy in January. As market participants speculate the FOMC to expand monetary policy further this year, investors may continue to diversify away from the greenback, but the U.S. dollar could face choppy price action if the Fed strikes a neutral tone for future policy.

The Upside

As the rebound in private sector activity gathers pace, with retail spending expanding throughout the second-half of 2010, the Fed may raise its economic assessment and talk down speculation for further easing as the outlook for growth and inflation improves. In turn, comments from the central bank could lead the EUR/USD to retrace the advance from earlier this month, and the exchange rate may fall back towards 50.0% Fibonacci retracement from the 2009 high to the 2010 low around 1.3500 to test for near-term support.

The Downside

However, the Fed may continue to cast doubts for a sustainable recovery as households cope with the tepid pace of expansion in employment paired with the depressed housing market, and the central bank may keep the door open to conduct additional monetary easing over the coming months as it aims to balance the risks for the region. Accordingly, the U.S. dollar may selloff against its major counterparts if the Fed shows an increased willingness to expand monetary policy further, and the EUR/USD may continue to retrace the decline from back in November as interest rate expectations falter.

How To Trade This Event Risk

Trading the given event risk is certainly not as clear cut as some of our previous trades, but comments following the rate decision could set the stage for a long U.S. dollar trade if we see the Fed curb speculation for additional monetary easing. Therefore, if the central bank head adopts an improved outlook for growth and inflation, we will need to see a red, five-minute candle following the announcement to establish a sell entry on two-lots of EUR/USD. Once these conditions are fulfilled, we will set the initial stop at the nearby swing high or a reasonable distance after taking market volatility into account, and this risk will generate our first target. The second objective will be based on discretion, and we will move the stop on the second lot to cost once the first trade reaches its mark in an effort to protect our profits.

On the other hand, the Fed may retain a cautious outlook for the region given the ongoing weakness within the private sector, and the central bank may keep the door open to conduct additional monetary easing over the coming months as growth and inflation remains subdued. As a result, if Chairman Bernanke shows a greater willingness to expand its emergency measures, we will implement the same strategy for a long euro-dollar trade as the short position mentioned above, just in reverse.

Potential Price Targets For The Rate Decision

Impact that the FOMC Interest Rate Decision has had on USD during the last meeting

December 2010 Federal Open Market Committee Rate Decision

The Federal Open Market Committee held the benchmark interest rate between 0-0.25% in December and pledged to keep borrowing costs at the record-low for “an extended period” in order to stem the downside risks for growth and inflation. At the same time, the central bank retained its $600B expansion in quantitative easing as the current rate of economic growth remains “insufficient to bring down unemployment,” but went onto say that the unconventional program will be “regularly” reviews as the recovery gradually gathers pace. Despite the dovish tone held by the Fed, the U.S. dollar advanced against its major counterparts following the announcement as investors scaled back speculation for further easing, but the substantial amount of slack within the private sector could lead the FOMC to support the real economy throughout 2011 as the fundamental outlook remains clouded with high uncertainty.

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To discuss this report contact David Song, Currency Analyst: dsong@fxcm.com