Fate of US Dollar Rests on Fed, Bernanke
Forex Markets prepared for a major injection of volatility this week, as all traders are now firmly focused on the outcome of the next monetary policy meeting to be conducted by the US Federal Reserve. This will finally be seen next Wednesday, and the main question will be whether or not the Fed believes the US economy is truly in a position to start working on its own merits and begin operating without the “helping hand” of monetary stimulus. Markets are currently expecting a $10 billion reduction in the Fed’s monthly asset purchases (which currently total $85 billion each month).
The final outcome will have important implications for all asset classes, not just forex. But it will be important for forex traders to monitor what happens in these other asset classes (for example, stocks and commodities) as this will have a correlated effect on currency prices as well. For instance, a bigger than expected reduction in stimulus will likely drive down the S&P 500, along with oil. This is because investors will have limited prospects for corporate earnings performance and for energy demand into the final months of the year. At the same time, we would likely see gold and the US Dollar move higher. From the gold perspective, removing stimulus would bring added uncertainty to the markets, and gold is generally used as a safe haven asset during times of increased uncertainty.
The Week Ahead in Forex: Potential Reasons for a Dollar Rally
The US Dollar is also traditionally looked at as a safe haven asset but its bullish reasons would not stop there. If the Fed removes stimulus, it essentially means that there will be fewer US Dollars running through the global economic system. Any time demand remains the same, while supply declines, prices will rise. This is true for any asset, and this is why we would see a major bull rally in the Dollar if the Fed decides to cut back on stimulus in an amount greater than expected.
On the other end of the possibility spectrum would be any case where the Fed surprises markets and decides to leave stimulus programs unchanged. Here, we would likely see major rallies in currencies like the Euro and Australian Dollar, as forex markets look for alternatives for long positions. If this were to occur, the Australian Dollar would likely be the big gainer on the week, as it tends to rally during times of certainty and also has some of the best yield reward of any major currency. For these reasons, carry trades like the popular AUD/JPY would likely rally to new quarterly highs.
In any case, next week should prove to be highly volatile, as forex traders have been waiting for this event for months. Forex traders should position themselves carefully before the final Fed announcement is made, as we will likely see strong moves in one direction or the other.