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Forex pairs in this Article » USDOLLAR, EUR/USD, GBP/USD, USD/JPY, AUD/USD, NZD/USD, USD/CAD
Dollar_Rally_Can_Turn_Severe_if_Taper_Concern_Taps_Fear_body_Picture_5.png, Dollar Rally Can Turn Severe if Taper Concern Taps FearDollar Rally Can Turn Severe if Taper Concern Taps Fear

Fundamental Forecast for US Dollar: Bullish

  • Fed Chairman Bernanke warns the market Taper is on the horizon
  • US Treasury yields soar above 2.5 percent
  • Dollar reversal strengthens as S&P 500 cracks critical 1,600
Fed Chairman Bernanke warned this past week that the era of limitless stimulus is coming to an end, leading the capital markets to convulse and US dollar to soar. Though the real policy change won’t be realized for some months, an overextended and overleveraged market still has a significant surplus of premium that will be worked off before the central bank actually ‘tapers’. Speculation on the timing and impact of this seismic policy change will present the market’s overriding fundamental concern for the coming weeks and months. And, at the very beginning of this market-wide tide change; it is imperative to remain vigilant of the possibility of escalation behind this development – from necessary repositioning to blind risk aversion. These two outcomes mark the difference between a modest but steady advance to a panicked yet aggressive surge for the dollar.

After four consecutive weeks under water, the Dow Jones FXCM Dollar Index (ticker = USDollar) posted its best weekly performance in three years. That positioned the US currency as the best performance amongst the majors with gains that ranged from the 1.4 percent climb versus the Swiss franc and massive 3.7 percent surge versus the New Zealand dollar. Taken alongside the biggest S&P 500 drop in 18 months and a neutral performance for the FX market’s carry trade benchmark (the yen crosses), it was clear how the market interpreted the Federal Open Market Committee’s (FOMC) policy meeting.

The policy gathering this past week was one of the Fed’s quarterly events where in addition to the standard decision and statement, the central bank also updates economic forecasts (unemployment, inflation, interest rates) and Chairman Bernanke hosts a press conference. Through shrouded in contingencies – ‘if data warrants’ – the group signaled it would look to taper its $85 billion-per-month purchases of Treasuries and mortgage-backed securities (QE3) in the near future. Against improved GDP and employment forecasts, Bernanke stated that stimulus purchases may be ‘moderated’ later this year and conclude around mid-2014.

While it is not a certainty that the US central bank’s rapidly growing balance sheet (now $3.47 trillion) will ease its pace, the shift in bias carries significant impact on the market. Over the past four years, investors have stretched their speculative positioning with market-based yields near historic lows and record levels of leverage employed. This seems to be the source of disconnect amongst many market participants and analysts. Many are surprised by the biggest weekly rally in 10-year Treasury bond yields in a decade and the sharp correction in US equities as the Fed is not likely to actually tighten (increase rates and/or sell assets) for some time. Yet, what we have experienced so far is not an ‘overreaction’ as front-loaded speculators are not interested in waiting for standard rates of return to catch up to the levels that would support current market prices.

Now, moving forward, the market will concentrate on determining when the Fed will demilitarize its stimulus effort. According to polls conducted by Bloomberg and Reuters of economists, the consensus amongst the academic set is for the first QE reduction to begin at the September meeting – a reasonable assumption as it is the quarterly event with forecast updates and presser – with a $20 billion reduction in pace (to $65 billion per month).

There is plenty on the docket that can illuminate / ignite speculation. For data, a consumer confidence survey, personal income and spending figures, the Fed’s preferred inflation read (PCE), housing statistics and factory orders report cover a wide view of the economy. Yet, speculators are likely to focus on the source of policy changes – the central bankers themselves. There are 9 major Fed board member speeches scheduled over the coming week. Voter or not, the market’s interest is piqued and exposed speculators are prone to paranoia. Most of the speakers are in fact non-voters; but they are also not worthy hawks that have supported taper before the June meet.

Some believe that the Fed will have already been shaken by last week’s Treasury and S&P 500 slump and subsequently defer the taper indefinitely. Yet, policy officials no doubt expected this reaction – hence their cautious tone. There is likely a significant degree of tolerance for capital market weakness before the FOMC change their new bias. That brings us to the intensity of speculative unwind. We aren’t in full fledged ‘risk off’. If we were, the carry trade (yen-crosses) would plunge and Treasuries rally as the flight to quality crashes through all other conventions of value. Fear can flare on arbitrary catalysts at this point, so it is best to simply watch for flames. – JK

--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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