Fed Sets Expiration Date on U.S. Dollar Downtrend

by: Ilya Spivak

Last week’s Federal Reserve monetary policy meeting offered little to beleaguered US Dollar bulls, with the most notable announcement being policymakers’ firm intention to complete QE2 in full and let the program expire as scheduled in June. While this is hardly unexpected, the conviction behind the timeline does carry implications for the greenback, effectively putting a loose expiration date on the current downtrend.

There is a compelling argument to be made for an increase in US bond yields after the Fed removes the external force bearing down upon them. Funding the gargantuan US budget deficit will require plenty of new bond issuance, which will increase the supply of Treasury debt available in the markets and pressure prices lower; because the price and yield for a bond are inversely related, this implies the rates attached to US debt will increase. The recent downgrade of the US credit outlook by Standard and Poor’s will reinforce this trajectory.

With this in mind, the Fed’s apparent commitment to end QE2 in June allows traders to size up their window of opportunity to borrow cheaply in Dollars for the purchase of higher-yielding assets before yields increase. While this points to continued selling of the greenback over the near term, fueling gains in risky assets and correlated currencies, it also suggests that the US unit may be on the cusp of a material reversal against the spectrum of its top counterparts over the weeks ahead. Notably, investors will surely wait to see how yields respond once QE2 ends for positive proof that the trajectory going forward favors the upside; how long this process plays out is unclear, and so putting a firm date on the US Dollar reversal is unfortunately impossible at present.

EUR/USD: Euro Poised to Follow Risky Assets Higher, 1.50 in Sight

Sentiment trends remain in focus, hinting the Euro is likely to extend its advance against the greenback as traders rush to capitalize on funding bets on risky assets in USD ahead of the QE2 expiry in June. The monetary policy announcement from the European Central Bank headlines the economic calendar, with consensus forecasts calling for Jean-Claude Trichet and company to hold the benchmark lending rate at 1.25 percent this time around after adding 25bps to borrowing costs in the previous month. This puts the spotlight on the ECB President’s post-announcement press conference as markets scour for clues on the timing of the next increase. As it stands, traders are pricing in 75bps in tightening over the next 12 months.

GBP/USD: Pound to Underperform as Bank of England Stays on Hold

While sentiment trends remain the dominant, correlation studies suggest their influence is weakening while that of the monetary policy outlook (not shown) is slowly gaining strength. This suggests that while the overall bias favors Sterling strength as risky assets remain well-supported, the UK unit may underperform other non-USD majors as the Bank of England holds both elements of monetary policy – benchmark interest rates and the asset-purchase target – unchanged once again. Given the BoE’s penchant to stay mum following the announcement, the next major event for monetary policy is likely to be the release of minutes from this week’s sit-down two weeks from now as markets size up the evolving voting pattern on the rate-setting MPC. April’s set of Manufacturing, Services and Construction PMI readings round out scheduled event risk.

USD/JPY: Yen Gains Likely as US Yields Remain Under Pressure

Yield spreads in focus, and the absence of any meaningful Japanese data puts the spotlight on a packed docket of first-tier US event risk including the ISM manufacturing reading as well as the all-important Nonfarm Payrolls jobs report. US economic data has notably soured over the past two months and more of the same is expected for most of this week’s headline releases, reinforcing bets on a dovish Federal Reserve and keeping downward pressure on US yields that promises to push the greenback lower against its Japanese counterpart, at least for the time being.

USD/CAD, AUD/USD, NZD/USD: Risk Appetite to Keep Comm Dollars Elevated

Risk sentiment trends continue to dictate the trajectory of the commodity bloc currencies, pointing to further gains against their US namesake as investors continue to indulge their appetite for USD-funded bets on higher yielding assets. The Reserve Bank of Australia’s interest rate decision headlines the calendar, with Glenn Stevens and company widely expected to keep borrowing costs unchanged at 4.75 percent. Another dovish outcome seems unlikely to prove especially market-moving considering a static RBA at least through the remainder of 2011, has been priced in for some months now. Canada's and New Zealand’s Unemployment reports as well as the former country’s Ivey PMI reading are also on tap.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.