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Tickers in this Article: UDN, UUP, FXA, FXE
The U.S. dollar is on the eve of a major reversal - at least it appears that way in the present environment. There are several key reasons as to why the greenback could recover, including Tuesday's FOMC statement, global GDP growth, recovering economic conditions in the U.S. and of course, commodities and oil.

The Interest Rate Paradigm
Before we get into the FOMC statement, it's important to take a moment to explain how and why currencies move. In the world of forex, currencies are backed by the interest rates each central bank pays for purchasing their money. The Fed Funds Rate in the U.S. is currently yielding 2%, which effectively means forex traders earn 2% when they are long the U.S. Dollar.

When you buy the U.S. dollar via forex, you are paid the active interest rate into your account daily. However, within forex, traders buy "currency pairs", meaning that you always buy one currency, while simultaneously selling the other. Take the euro and U.S. dollar for example. In forex, this is denoted as EUR/USD. The pair always holds this same format and thus, when you buy the EUR/USD you are long the euro and short the dollar. Conversely, when you sell the EUR/USD you are short the euro and long the dollar. (To begin with the basics, read Getting Started In Forex and Wading Into The Currency Market.)

Here's where interest rates come in however. In forex you receive interest daily on the currency you are long and pay interest on the currency you are short (when shorting, we are borrowing money, which is why we pay interest daily). In the case of the EUR/USD, the ECB is presently yielding 4.25%, while the FOMC is presently giving 2%. Subtracting the lesser from the greater, we see that the interest rate differential is 2.25%. This means if you are long the EUR/USD, you are credited every day at 5:00 PM EDT. If you are short the EUR/USD, you pay interest each day, as because you are borrowing money for the euro, you pay 4.25%. This is better known as a "carry trade" where one borrows in a low interest rate currency and invests in a high interest rate currency. (To learn more, read Currency Carry Trades Deliver.)

Higher interest rate currencies generally trend upwards over lower interest rate currencies, unless...

FOMC Poised to Move the Greenback
On Tuesday July 5, the FOMC voted to keep interest rates on hold at 2% while also keeping the discount rate steady at 2.25%. While this may sound like a "non event", Tuesday's decision is actually the headwind of a larger paradigm shift. The U.S. dollar has been severally beaten down over the past six years, due to many factors including national debt, trade deficit, credit conditions, oil, real estate, slowing GDP growth and trade policy.

All of the aforementioned have lead to the low 2% interest rate from the FOMC, which has helped to depress the dollar, as forex traders borrow the greenback to buy higher yielding currencies like the Australian and New Zealand dollars, euro and pound sterling. The higher an interest rate, the greater the chance the currency is in an uptrend. Here's the rub: in Tuesday's statement, the FOMC signaled that the U.S. economy is slowly improving, which could mean higher interest rates ahead.

Just take the second paragraph of the June and August statements for example. In Tuesday's statement the FOMC said, "Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth." This exact statement was bumped up to the second paragraph in the August statement, from the fourth paragraph in the June statement.

In the world of the FOMC nothing happens by chance and everything has a purpose. The FOMC deliberately moved the aforementioned passage up two paragraphs, as recovery is likely in the cards for late 2008 and 2009. What's more, in its latest release the FOMC also stated, "Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."

The cure for inflation is higher interest rates. Thus, both elevated inflation expectations coupled with GDP growth recovery should translate to higher interest rates from the U.S. As previously mentioned, higher interest rate currencies generally go up relative to lower interest rate currencies.

The Euro Area Kicker
Another piece of the puzzle comes from European Central Bank (ECB), which has held interest rates amazingly high over the past year, while virtually every other advanced economy has lowered rates to stimulate growth. In fact, in the June meeting, the ECB actually raised rates, citing short-term second round inflation as the culprit.

What does that mean? It means that the ECB (through its overly hawkish stance) has likely clipped Euro Area liquidity to a point where GDP growth will start suffering. The ECB reports interest rates on Thursday, and will likely hold rates steady at 4.25%, based on inflation. However, if the ECB finally sobers up and actually lowers rates, the event would mean a narrowing interest rate differential between the euro and dollar, and the reason to hold the euro long will fade. Call it a U.S. dollar reversal, if you will, hand delivered by the ECB.

Bottom Line
Forex markets are risky however, so for most investors it may not be advisable to simply jump into currency trading. However, within equity markets, investors can capitalize on movement in the dollar by buying or selling an ETF such as the PowerShares DB U.S. Dollar Bullish (AMEX:UUP) and the PowerShares U.S. Dollar Bearish (AMEX:UDN). For those seeking movement overseas, there's also the CurrencyShares Australian Dollar ETF (AMEX:FXA) and the CurrencyShares Euro Trust ETF (AMEX:FXE).

To learn how currency ETFs work, read ProfitFrom Forex With Currency ETFs and Currency ETFs Simplify Forex Trades.

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