As the last month of the year gets underway, central banks and oil cartels will convene to determine how to adjust current policy relative to the disappointments of 2016. One of the larger disappointments is the lack of logic perceived in multiple markets as shown by low oil prices and inverted swap spreads.
Inverted swap spreads are the pricing of government debt as riskier than corporate debt.
Starting on December 3, Mario Draghi of the European Central Bank will make a much-anticipated announcement as to whether or not they will expand their quantitative easing measures that began in January of this year. Later that same day Janet Yellen will testify before the joint economic committee of the U.S. Congress (JEC), where she will likely be asked how she expects the economy to react to “gradual rate hikes”. Her answers could be very telling regarding the Federal open market committee’s December 16 rate announcement, where the Federal Reserve is expected to raise interest rates for the first time since 2006.
Adding to the fundamental drama, on December 4th, OPEC will convene to discuss production measures for 2017. Should they decide to reduce production, oil could see a long-awaited squeeze higher. Oil is very important in the Forex market as many economies, and their respective currencies are dependent on the price of oil.
When dealing with markets, simple questions can have sophisticated and rather complex answers. An example of a complex answer would be looking at the implied volatility of options on EUR/USD to tell you what is expected from the December 3rd economic events. One popular implied volatility market is the volatility index or VIX that displays implied volatility on futures contracts of the S&P 500. The higher the price, the more volatility or fear is expected.
Currently, a three-week contract of EUR/USD implied volatility is sitting at its widest levels on records going back to 2006. Surprisingly, volatility expectations are higher than was seen in the depths of the credit crisis in the fall of 2008. While you do not have to know what the outcome will be, it can be very helpful to know that volatility as expected at the beginning of the month.
What’s the Trade?
If you are familiar with the opening range breakout concept, the December opening range breakout would be a good time to put it to use. If you are not familiar about the opening range breakout, read here. Due to the crowded nature of the short euro/ long US dollar trade, any disappointment towards the beginning of the month could set up for an aggressive reversal of the trend that began on August 24th.
Understandably, the biggest fears in the market are that the ECB does not ease or eases less than expected. A disappointment of this measure would likely result in EUR strength. Another surprise will be if Janet Yellen tips her hand that the Federal Reserve is looking to be less aggressive than the market is pricing right now, which could cause the US dollar to reverse its gains seen since October 15. Either way, the EUR/USD short trade is very crowded and given that these are the two largest currencies in FX, any changing of the guard would be a significant event and would set up for a wild ride in the close of the year.