Thanks to the FOMC minutes and weaker economic data abroad, the U.S. dollar enjoyed a nice rally against most of the major currencies this week. The mere possibility that the U.S. central bank could start to taper off its monthly asset purchase program as quickly as next month sent investors rushing to adjust their positions. The unevenness of U.S. data makes it hard to believe that the economy is strong enough to withstand less stimulus but Fed President and FOMC voter Dudley made it clear that small adjustments could be made to ease the pain of stimulus withdrawal. The question is now where Bernanke, our mild mannered inflation dove stands. The head of the U.S. central bank will be delivering his semi-annual testimony on the economy to Congress next week. It is always an interesting session to watch particularly since there is a colorful question and answer session. If he agrees that changes to the monthly asset purchase could be made, the dollar could extend its gains quickly. However if he vigorously defends the central bank's ultra easy monetary policy and downplays the need to slow or stop their asset purchases, it could kill the dollar's rally.
Meanwhile there is another game of chicken being played in the U.S. government this week. A package of mandated spending cuts worth $85 billion known as the sequester are expected to kick in on March 1st. If Republicans and Democrats want to avoid these budget cuts, they need to come to a compromise and so far, there is little sign that they are willing to do so. Based on the rise in U.S. stocks today, equity traders aren't worried perhaps because we've been down this road before with the debt ceiling and survived. Also, the numbers aren't enormous - only $50B worth of cuts are expected this year, or the equivalent of 0.5% of GDP. While any type of budget cut will be painful for the U.S. economy and erode U.S. growth, Congress will most likely agree on a last minute deal. They could also make changes or cancel the cuts once they start to see the impact on the economy. Psychologically however, allowing the sequester to happen would still be negative for the dollar in the near term but over the long term, the impact should be nominal.
As for economic data, we only expect tier 2 economic reports next week. This includes house prices, consumer confidence, new home sales, durable goods, revisions to GDP, personal income, personal spending and the ISM manufacturing reports. All of these numbers will take a back seat to Bernanke's testimony.