Option Expiration Creates Volatile Stock Trading Session

James Hyerczyk from ForexHound.com at 02/20/10

U.S. stock indices traded sharply higher after recovering all of Thursday’s after hours break following the discount rate hike by the Federal Reserve.  Equity traders shrugged off Thursday’s action by the Fed after realizing the hike in the discount rate was not a tightening of the Fed’s monetary policy. 

Late in the trading session, buyers disappeared and the equity markets turned negative for the day. Option expiration jitters created a choppy two-sided trade. All three indices ended up trading flat to lower. A weaker Dollar next week could fuel another leg up in the indices.

March Treasury Bonds and Notes closed higher on Friday. Oversold conditions were most likely the major reason for the rally. In addition, bond traders seemed to be in agreement with the Fed that the discount rate hike was not a sign that the monetary policy is tightening.

April Gold and April Crude Oil were able to overcome early downside pressure after the Dollar soared to the upside. The gradual sell-off in the Dollar throughout the day helped drive both crude oil and gold higher by the close. The bullish action by both of these markets indicates that speculators are betting on a break in the Dollar.

The U.S. Dollar Index finished higher on Friday while eking out a small gain for the week, but the trading action during today’s session indicates that it may be overbought. Following a strong overnight surge to the upside following the Fed’s discount rate hike late Thursday, the Dollar topped early in the trading session then struggled to stay positive the rest of the day.

By mid-session it looked as if traders were shrugging off the Fed’s discount rate hike.  Traders seemed to be treating the action by the Fed as something the central bank had to do to encourage banks to borrow from the private sector. At the start of Friday’s trading session, investors reacted as if the Fed had begun to tighten its monetary policy. This was not the case, however as the Fed reiterated its position through the media that interest rates will not rise for an “extended period”.

To recap the week, the Federal Reserve hiked the discount rate 25 basis points to 75 basis points late Thursday, sending the U.S. Dollar sharply higher. This buying spree spilled over into the overnight trade pushing the Dollar Index closer to the all-important major 50% level at 82.63.

The discount rate hike by the Fed was implemented to encourage banks to borrow more from the private sector. This move did not reflect a change in monetary policy however despite market reactions and analyst commentaries to the contrary.  Some had interpreted the action by the Fed as a move towards monetary-policy normalization although the Fed insisted this was not the case. As far as the Fed is concerned, its official statement is that interest rates will remain low for an “extended period”.

What it could mean is that the Fed is comfortable enough to begin hiking rates although it is not a change in monetary policy. In addition, I think it sends a clear signal that the emergency supply of liquidity that helped fund the economic recovery is over. It could also be interpreted as a psychological move by the Fed for investors to get ready for the future course of monetary policy.  This action by the Fed basically signaled that future rates are more likely to go up, rather than stabilize or go down.

Some analysts called the move by the Fed a surprise.  The timing may have been a surprise, but a discount rate hike was mentioned twice by the Fed during the last two weeks. In Bernanke’s testimony to Congress on February 10th, he said the discount rate would have to be raised “before long”.  The FOMC minutes released on February 17th stated that a discount rate hike “would soon be appropriate”. As far as the timing is concerned, it looks as if the Fed wanted to separate the hike from its normal FOMC activities in order to emphasize that this hike was not a change in monetary policy.

Stock traders caught on quickly to what the Fed meant with its discount rate hike. The strong rally in the equity markets helped drive up demand for higher risk assets. The Dollar began its topping process early in the trading session just after the EUR USD bottomed.  The Greenback started to break as profit-takers took over while the Euro turned positive.

The March Euro posted a daily closing price reversal bottom. This potentially bullish pattern could trigger the start of a near-term short-covering rally if confirmed on Monday. The first short-term objective was already reached at 1.3615, setting up a further rally to 1.3656.

A rally through 1.3656 could prove interesting. This will mean that upside momentum is building which could trigger a further rally to the last main top at 1.3788. A rally through this price will turn the main trend to up and set up the possibility of a huge rally back to 1.4011. 

This may sound improbable, but there are a record amount of shorts in the market according to the CFTC’s Commitment of Traders Report. If some event happens that spooks the weaker shorts, then this scenario could take place. Last week it was reported that China and Russia had bought Euros so additional buying activity by these two nations could be the catalyst needed to trigger a short-covering rally. Furthermore, an injection of cash by the European Union or the International Monetary Fund into Greece will also drive shorts out of the Euro.

The March British Pound started the day sharply lower after a worse than expected U.K. retail sales report. This report was another signal that the U.K. economy was falling further behind the U.S. economy.  If the Euro rallies, traders may begin dumping on the British Pound. Oversold conditions could trigger a mild short-covering rally next week before this market moves lower once again.

A rally in the Euro will help support the March Swiss Franc. This is because it is diminishing the chances of another round of intervention by the Swiss National Bank. Friday’s closing price reversal bottom is a strong sign that the buying is greater than the selling at current levels.

The hike in the discount rate by the Fed has caused Japan to lose its short-term interest rate advantage against the U.S. Dollar. This has turned the Japanese Yen into the main carry trade currency once again. The daily chart indicates the March Japanese Yen is oversold, but the weekly chart indicates more downside is likely.

The weakening Dollar triggered a turnaround in the crude oil and gold markets on Friday. The subsequent rally in these two markets helped rally the March Canadian Dollar to its highest level in 4 weeks.