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3 Dollar Trades Powered by the Fed

3 Dollar Trades Powered by the Fed

Kathy Lien, Technical Strategist

Clear-cut guidance from the Fed with regards to the tapering of asset purchases essentially marks an unofficial bottom for the US dollar against the euro, yen, and other currency counterparts.

The US dollar (USD) soared against all major currencies after the Federal Reserve effectively green-lighted a dollar rally by growing more optimistic about the US economic outlook and saying point blank that they may moderate asset purchases this year and end them completely by mid-2014.

Heading into the Fed meeting, we were looking for more clarity about the timing of potential changes, and Fed Chairman Ben Bernanke couldn't have been more specific. He started the press conference by discussing all the reasons why investors should not expect a rate hike, and now we understand that he was trying to manage the market's expectations for the words that followed.

After saying that meeting the inflation or unemployment targets does not automatically lead to a rate hike, Bernanke started to talk specifically about the plans to taper, and investors got a hint of the Fed's potential aggressiveness from the Federal Open Market Committee (FOMC) statement.

While the central bank cut the GDP forecasts and one Fed President (Bullard) voted for looser monetary policy, the majority felt that the downside risks diminished since the labor market improved.

In fact, the central bank even dropped its forecast for the unemployment rate, kicking off a rally in the dollar that gained momentum after Bernanke said the Fed plans to reduce asset purchases in 2013.

The question now is whether the clarity in Fed policy has created a bottom for the US dollar, and we believe it has. While the Federal Reserve has gone out of its way to say that tapering does not equal tightening, by reducing asset purchases and announcing plans to stop buying completely, they have the exit clearly marked.

If we contrast that with what other central banks like the Bank of Japan (BoJ), Bank of England (BoE), and European Central Bank (ECB) are doing, the Federal Reserve's policy bias is extremely positive for the US dollar.

Also, given that the central bank intends to cease quantitative easing (QE) as early as mid-2014, we can't expect them to go from full on in December to nothing in June. The Fed will want to reduce asset purchases gradually and give as much room as possible to see how the market responds.

We have called for Fed tapering in September, and we continue to believe that is the right timing. Shifts in monetary policy expectations led to the aggressive selloff in the US dollar in late May and early June, and adjustments in expectations could once again change the trend for the dollar.

US ten-year bond yields have spiked in reaction to the FOMC announcement, and this rise will only make US fixed-income assets even more attractive to foreign investors.

In a nutshell, we believe that the dollar has bottomed, and that means the US dollar index could rise back to 83, USDJPY could go to 100, and EURUSD could increase to 1.31.

Tomorrow's Philly Fed, existing home sales, and leading indicators reports will now take a backseat to post-FOMC position adjustments.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.