Bernanke Green Lights Dollar Rally

There you go folks -- Fed Chairman Ben Bernanke confirmed this morning that the central bank could reduce its pace of asset purchases "in the next few meetings." It took a while for Bernanke to make his point and the dollar endured a rollercoaster ride as a result but the takeaway from his speech is clear which is that the Fed is serious about winding down QE and all of the speculation surrounding this possibility is validated. The U.S. dollar has been on a tear since the beginning of the month and should extend its gains now that Bernanke green lighted the rally. While the AUD and NZD have been hit the hardest by the gains in the dollar today, the biggest milestone was reached in USD/JPY, which rose to a fresh 4.5-year high.

Here's When
As long as there isn't a surprise contraction in the U.S. economy in the late second and early third quarters, we believe the Federal Reserve plans to reduce monthly bond purchase in September. Fed President and FOMC voter Dudley was a bit more specific than Bernanke this morning - he said it could bethree-to-four months, which puts us right into the next meeting with a quarterly press conference from the Fed Chairman. This is a major change in policy and Bernanke will want to manage the market's future expectations -- the press conference gives him an additional opportunity to do so.

Bernanke actually started his testimony sounding cautious, causing the dollar to tank. He said the job market was weak despite recent gains and warned that premature tightening risks slowing or ending the overall recovery. On tapering, he said "we may or may not sell assets" and they could "raise or lower purchases pace depending on data." However almost immediately he added that they could reduce the pace of purchases in the next few meetings if economic data continues to improve and this sent the dollar soaring. While the Fed Chairman is worried about the high level of unemployment and the "substantial drag" that fiscal restraint puts on 2013 growth, inflation is low and the current level of interest rates is adding to employment, wealth and the housing market. He spent a lot of time talking about an exit strategy, saying that winding down QE will be the first part of that plan and that allowing securities to roll off could be part of their strategy. His concerns about frothiness and bubbles also suggest that they are prepping for an exit even though they will take baby steps towards it.

And It -- The USD -- Is Ready To Roll
Now that the dollar rally has Bernanke's blessing, the greenback could extend its gains, especially if tomorrow's euro-zone PMI numbers surprise to the downside and ECB President Draghi repeats that more stimulus for the euro zone is likely. The FOMC minutes will be released in a few hours and while it still poses a risk to the dollar, the impact should limited because the Fed had stale data at that meeting.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.