Post 1

Rise of the Dollar 

Federal Reserve surely likes to play word games with financial participants. From "patient" to "transitory factors", the beautifully crafted FOMC statement is a truly linguistic masterpiece, yet the words in it bear almost no practical meaning. Over time, Fed had become more vague in delivering their policy intentions. 

But the core factor is here to stay, that is the divergence of international monetary policy. U.S. had got a bit ahead of themselves, they are the only developed country in the world right now who signals tightening.

So U.S. lift-off is not a question of if but rather a question of when. This fact is being priced in tremendously since Q3 2014. (Click to enlarge)

(Source: Barchart)

This great USD bull trend (+25% in 9 months) is further reinforced by investor expectations. U.S economy was deemed healthy enough for Federal Reserve to start raising rates. On the flip side, other countries are still struggling to return to economic recovery or escape from deflation.

A trend lasts until it doesn't. At March 13th, the market suddenly realised it had gone too far and become doubtful on the prevailing reasoning. Perhaps U.S. economy growth is not gaining traction. Perhaps QE bazooka by ECB (started at March 9th) can really revive Europe. 

Hence comes the abrupt unwind of long USD positions after March FOMC meeting. The move was exacerbated by the lack of liquidity towards New York close, where London was closed and Asia was sleeping. EUR/USD drops 500 pips within minutes. 

(Source: Zerohedge)

(Source: Barchart)

For sure, Federal Reserve is a dollar watcher closer than everyone else, and even they could be surprised by the move. One could argue that strong dollar hurts corporate America and Fed don't mind "talking down" the dollar. But to induce volatility into currency markets does not benefit anyone except short-term speculators. Being aware on this precedence, the April FOMC statement doesn't even has "dollar" mentioned once.

Takeaway from Fed

Perhaps the more relevant takeaway from recent FOMC statement: Fed is transitioning towards a data-dependent policy. Instead of putting down set dates as in tapering process, and unlike forward-guidance that sets forth policy objectives, Yellen signals the lift-off would require (1) a strong labor market and (2) inflation reaches 2% in the medium-term. 

This likely to shift investors' focus to economic releases, especially the monthly employment report. As PCE deflator (the inflation measure Fed prefers) is not directly influenced by financial markets, inflation breakevens shown using TIPS and treasuries are watched as an alternative.

I would argue the data-dependent policy can be misleading. The current financial system can well digest the "known unknowns" i.e. the scheduled economic releases and press conferences, but might not able to absorb the shock when Fed raises rates. 

A very recent (and relevant) analogy is as ECB starts bond purchases and European bond yields goes below zero, the bond market rightfully ignores the regular comments from Draghi. But as soon as a bond manager starts saying German bund is "short of a lifetime", the bond market crashes in due course. There were no bids in near sight, effectively causing a liquidity squeeze and sent German bund yield from 5 basis points to over 70 basis points. To put in perspective, it is equivalent to a drop of 6% in price in a market where average daily move is +/- 0.5%.

(Below is a chart of German bund yield in percentage. Bond yield moves inversely to bond price.)

(Source: Wall Street Journal)

Liquidity Trap

Liquidity is a real concern as lift-off draws near. The issue is what Nassim Taleb coined as a "unknown unknown", an uncertainty factor that is unable to be properly quantified. There is a saying, the liquidity is gone just when you needed it the most. Other than not public acknowledging this, regulators are distilling a misguiding confidence into financial markets by directing participants towards other factors. 

As Fed continues to play the game of "extend and pretend", keeping ZIRP as long as markets can take, condoning the reckless share repurchases in stock markets, allowing cheap credit to flow to every corner of the system, a black swan event (by definition) cannot be ruled out. When such event arises, most existing risk management methods could turned invalid, stop losses might turned sour, and credit would not be readily available in a cheap cost. 

One might be tempted to short the market using leverage (futures) but must stay mindful that using borrowed money could face margin call when brokers are under stress. A more proper way is use option strategies, preferably those with limited downside.