Dollar Stumbles, Risk Rallies after Fed Decision but Will it Last?

• Dollar Stumbles, Risk Rallies after Fed Decision but Will it Last?
• Euro Rally Triggered by Sentiment, Sustained by ECB Bond Buying
• British Pound Traders Waiting to See if the BoE Joins the Stimulus Club
• Australian Dollar Dependent on Capital Markets as Rate Expectations Toppled
• Japanese Yen: The Talk of Intervention Continues
• Swiss Franc Sees Incredible Extension on Already Prominent Rally
• Gold, Through All the Volatility, Manages Another Record High Close

Dollar Stumbles, Risk Rallies after Fed Decision but Will it Last?

It's only fitting that after US equities suffer their biggest single daily loss in years on Monday that the markets would turn around for the biggest rally of 2011 the following session. Volatility begets volatility. However, what traders should really be interested in is whether this dramatic about face is a genuine reversal or merely a temporary correction that is showing the effects of the exaggerated trading conditions of the past few weeks. This is not an easy question to answer – not because the fundamental drivers are difficult to ascertain; but rather the sentiment behind the markets is fickle. At the very least, the high level of correlation between FX, bond yields, equities and commodities means all the markets are still following the same catalyst. That means that should the US downgrade, European Union sovereign debt troubles, Chinese economic and financial slowdown or any other prominent catalyst leverage the threat of a global crisis; investor confidence could collapse across the board.

Taking stock of the developments of the past 24 hours, it is interesting to note while the S&P 500 put in for a remarkable 4.7 percent rally; the Dow Jones FXCM Dollar Index (ticker = USDollar) only slid 0.8 percent – a hearty retracement but not deep enough to overtake the previous session's lows. The source for both moves was the Federal Open Market Committee's (FOMC) rate decision. The market has long ago written off any chance for a change to the actual benchmark rate; but there was still a holdout for further stimulus. And, in the absence of further economic/market support; the market was certain that there would be better guidance for policy moving forward. The immediate reaction to the news was centered on the lack of QE3-specific language. Those dependent on government support to keep their positions in the green (equities, speculative commodities, mortgage backed securities, etc) were looking for an explicit announcement for a third round of central bank asset purchases. When the market was clear that wasn't in the cards, risk appetite retreated. However, that pullback found a floor quickly and a strong bid followed quickly in its wake. Why? In the commentary, the policy group dropped the “extended period” language that the market had come to interpret as potential policy reassessment in 2-3 months and said rates would be on hold through 2013.

Is an extended period of exceptionally low rates quantitative easing? Not in the technical sense. However, it does keep rates exceptionally low to encourage investment, consumption; and it also encourages a shift to longer-dated US debt. The promise of low rates for more than two ultimately does little to truly stabilize capital markets to encourage risk taking. Though, it does offer a cue for a breather. That said, even if risk aversion does kick back in; it is important to remember that the greenback still requires panic and a wholesale need for liquidity to climb.

Related:Discuss the Dollar in the DailyFX Forum, John's Video: Why Did the Dollar Drop When the Fed Passed Over QE3?

Euro Rally Triggered by Sentiment, Sustained by ECB Bond Buying

The European Central Bank reportedly bought Italian and Spanish government bonds for a third consecutive day Tuesday. Some estimates put the policy authority's purchases through the session to 10 billion euros – a sizable sum in volatile markets. Their effort is clear when looking at the yields on the 10-year Italian and Spanish notes (not to mention the Greek, Portuguese and Irish equivalents). Certainly the ECB's efforts are significant; but they have been lucky to find a favorable sea change in capital markets through the previous session. Should these tides shift back once again; the financial disorder in the Euro Zone could once again sabotage their efforts. In the upcoming session, we should watch the scheduled Italian bond auction as an updated litmus test for market confidence; but our real interest will remain underlying sentiment trends.

British Pound Traders Waiting to See if the BoE Joins the Stimulus Club

With a perceived improvement in Euro-area market conditions and a drop from the dollar, Cable would naturally rally. Yet, the sterling hasn't done well against its euro, yen and high yield counterparts. This relative performance reflects the true lack of conviction behind the pound. Things could very well change for the currency in the upcoming session as we are expecting the BoE's Quarterly Inflation Report. This is a more timely minutes; and from this statement we could see the BoE join the ECB and Fed with a lean towards further policy easing going forward.

Australian Dollar Dependent on Capital Markets as Rate Expectations Toppled

All trades or investments made are made on the assessment of risk versus reward. The higher the potential return, the greater the tolerance for risk usually is. With a benchmark yield of 4.75 percent, we would expect the Aussie dollar's tolerance for negative winds to be substantial; but it is interesting to note rate expectations carry more weight than current rates. That said, the 12 month forecast now calls for 130bps in cuts…

Japanese Yen: The Talk of Intervention Continues

With USDJPY skipping along 76.50, there is little wonder intervention is on everyone's mind. There is an assumption that the BoJ and/or Finance Minister will act at a certain level – though they have repeatedly said volatility was their primary concern. So far this morning, we have seen no sign of manipulation. But even if we did, look at how little last week's effort accomplished – we have completely retraced the move.

Swiss Franc Sees Incredible Extension on Already Prominent Rally

The Swiss franc is in a league of its own. The currency rallied 768 points against the euro and 969 points against the British pound at its peak through the previous session. What makes the performance even more impressive is that the subsequent retracement on risk appetite trends found a tempered dip from the franc. The SNB has long been out of ammo. A true reversal requires euro confidence and risk appetite.

Gold, Through All the Volatility, Manages Another Record High Close

Sentiment would turn positive through Tuesday's session and so too would the equities market. Yet, regardless of this intraday shift in confidence and capital markets, gold wouldn't give up its positive close. The previous metal placed both a fresh record close and intraday high through the end of the session and buying is picking up into the new day. As long as the larger troubles persist; the metal will hold fast.

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Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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