The Foreign Exchange Market Will Grade Mr. Bernanke's Next Move

Includes: FXE, UDN, UUP
by: John M. Mason

Will the Open Market Committee of the Board of Governors of the Federal Reserve System choose another round of monetary easing?

Or, will the Open Market Committee continue on its current path whatever that is?

I believe the decision will be graded very quickly in the foreign exchange markets.

In fact, I believe that foreign exchange markets are very concerned that the Federal Reserve will go in for another round of monetary easing and have already begun to price this decision into the value of the United States dollar.

Look at the trade-weighted value of the dollar against other major currencies as presented by Federal Reserve data. Since about the beginning of August, when the talk about a new round of Federal Reserve easing started to increase, the value of the dollar has fallen by almost 4%.

Also, since the beginning of August, the value of the dollar against the euro has declined by almost 6%.

One should note that in the past two weeks or so, the value of the euro has strengthened as participants in the foreign exchange markets have responded to the efforts of the European Union get its act in order and to form a European banking union. In effect, markets have returned more to a risk on status as the yield on 10-year German bonds have risen as investors who had fled risk and placed their funds in these German securities and brought yields to near record lows. The two countries whose fiscal situations were most under fire, Spain and Italy, saw the yields on their bonds drop substantially below "unsustainable" levels. And, yesterday, the German constitutional court rejected efforts to block the creation of the European Stability Mechanism ... a positive move for the continued use of the euro

If the efforts of the EU to move forward on the attempts to achieve greater economic coordination and stabilization continue to draw favorable attention, then some of the extraordinary pressure on the euro will be lifted. If this pressure is lifted, then the weakness of the United States dollar will become more apparent.

The value of a foreign currency is relative. With the exception of two relatively short periods since the dollar was floated in August of 1971, the value of the dollar has declined against most major currencies of the world. That is, until the world went into a recession in 2008. Since then, as relative weaknesses have shown up in Europe and other parts of the world, the value of the United States dollar has fluctuated as periods of crisis have shown up and disappeared in other areas.

In my view, the value of the dollar is ready for another short-term decline. I believe that any sign of a move to more quantitative easing on the part of the Federal Reserve will be taken as a reason for foreign exchange traders to sell the dollar.

Even so, I believe that the price of the dollar will remain soft if the Federal Reserve decides to stay where it is policy wise. This, of course, depends on whether or not the EU continues to move ahead with its rescue plans, its banking union and with its efforts to craft a fiscal union.

Excess reserves in the banking system still top $1.5 trillion. Even if the Federal Reserve does not ease up further, the Fed still must deal with all of these excess reserves if the commercial banks really start lending again.

What is the Fed going to do with about $1,650 billion in U. S. Treasury securities on its balance sheet and another $844 billion in mortgage-backed securities on its balance sheet. Is the Fed just going to dump these securities on the open market once banks start lending again?

Furthermore, what about the fiscal cliff? Is the government really going to allow spending to be cut back as it is now programmed? Will either presidential candidate, once elected, get the federal deficit below $1.0 trillion over the next three to four years?

How can the financial markets handle $1.0 trillion in securities coming off the Fed's balance with another $1.0 trillion of government debt coming to the market year-after-year from future deficits?

Are American finances under control? Can the central bank really have any control over credit creation in the next four or five years?

These are just two reasons why I believe that the value of the dollar will continue to decline over the longer-run.

I believe that the response to the upcoming announcement of the Federal Reserve will elicit a response from foreign exchange markets. I believe that this response will be indicative of how traders in the foreign exchange markets really view the fiscal and monetary policy of the United States government.

I don't believe the response will be positive tomorrow. And, I believe even more strongly that the future trend in the value of the United States dollar will be downward.

I further believe, as Paul Volcker has stated, that the price of a nation's currency is the most important price we have to take care of.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.