Fed Policy And The USD

No major U.S. economic reports are scheduled for release, today. so we'd like to talk about the uncertainty of the Federal Reserve's monetary policy and its impact on the U.S. dollar. Since the beginning of the year, we have seen some interesting developments in the foreign exchange market as the U.S. dollar has behaved very differently against all of the major currencies. We have seen significant dollar strength against the Japanese Yen and significant dollar weakness against the euro. Other currencies like the British pound for example are more or less treading water. While it can be said that country specific factors are driving the euro higher and the yen lower, it is also the uncertainty of the Fed's monetary policy that has led to the inconsistent performance of the U.S. dollar.

Fed Plants Idea Into The Minds Of Investors, Sparking Uncertainty
When the Federal Reserve released the minutes from December monetary policy meeting earlier this month, they shocked the markets by revealing that a few members wanted to phase out asset purchases this year. Economists on Wall Street were quick to respond by saying it wasn't a game changer for the U.S. dollar because a "few members" most likely meant only one or two and it was far too early to seriously consider ending Quantitative Easing. However the sharp rise in U.S. bond yields suggests that investors felt otherwise. By planting the notion into everyone's minds, as economic data continues to improve investors will start think that the Fed will grow more serious about ending asset purchases this year especially after the semi-hawkish comments from Fed Presidents George and Bullard, two new members of the FOMC.

Potential Impact On Existing Rallies In USD/JPY And EUR/USD
For USD/JPY traders, the mere possibility of the Fed phasing out asset purchases has been enough to drive the currency pair higher alongside U.S. yields. For EUR/USD traders however, the certainty of the ECB keeping monetary policy on hold for the rest of the year overshadowed the Fed's possibilities. It is these reasons why this week's U.S. economic reports and comments from Fed officials including Ben Bernanke are so important. The sustainability of the USD/JPY rally hinges on good U.S. data and the lack of dovish comments from Fed officials. The rally in the EUR/USD also relies on the uncertainty of Fed policy. Therefore as long as central bank officials don't change their views by sounding any more dovish or hawkish, the rallies can continue. As for U.S. data, as long as there aren't any major surprises and gradual improvements, it should not pose a major threat to the existing rallies.

There were no meaningful U.S. economic reports on the calendar this week but between retail sales, inflation, industrial production housing, manufacturing and consumer confidence reports this week, we should get a significant amount of additional clarity on the current state of the U.S. economy. We know that the labor market continues to improve but the key is consumer spending. Economists are looking for a minor slowdown in growth, which would be negative USD/JPY and positive for the EUR/USD but if holiday shopping proves to be stronger than expected, we could see a more substantial rally in USD/JPY. The Federal Reserve's Beige Book is also be important to pay attention to because the data is for the month of December while the Beige Book findings are be more current.

Eight Fed Officials Scheduled To Speak This Week: Only Three Matter
There are also 8 Federal Reserve officials schedule to speak this week on the economy and monetary policy. Bernanke's speech at 4pm ET Monday afternoon in Atlanta will be the one to watch along with the comments from Boston Fed President Rosengren. Everyone else except for Evans who shared his views last night are not voting members of the FOMC this year. Evans is openly dovish and his view that rates will remain low until 2013 is not surprising. He's confortable with the current level of monetary policy and is optimistic about the housing market but wants a higher pace of job growth and less volatility. Bernanke is also a dove who is oftentimes more cautious and less optimistic than his peers so we can't rule out the possibility of negative comments that could hurt the dollar. Aside from talking about monetary policy and the long-term challenges facing the U.S. economy, he will also take questions from the audience, which can always get hairy. Nonetheless, clarification in monetary policy is what the market and the dollar will be looking for this week and if we get it, we could see additional volatility.

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