Over the past few weeks the main focus of currency markets has been on some of the positive developments emerging out of the eurozone. Draghi’s OMT initiative elicited a particularly positive response when the details were announced last week. However, it is also the case that the dollar has been subject to consistent selling pressure - since late July, the dollar index has fallen by 4.6%, a sizable decline that has attracted less critical comment than might have been expected.
The main catalyst for the dollar’s downward drift has been the continuing malaise in the labour market, and the Fed’s vow to do something about it. On Thursday, the FOMC will likely extend their interest rate guidance out past 2014, and commit to more asset purchases. Fed officials are clearly concerned over the lack of growth; they also fear that if Washington fails to arrest the fiscal cliff before the end of the year then the economy could easily fall back into recession.
Although more QE is definitely coming, less clear is what the size and timing will be. One interesting suggestion is that Bernanke will opt for an open-ended approach on this occasion, where he announces QE but does not specify how much or when. Strategically, this gives risk assets and high-beta currencies some reassurance that the Fed will be there as a backstop in case the economy deteriorates. At the same time, it might take some of the heat off Washington, as politicians would be safe in the knowledge that in the event of inaction, the Fed would be ready to respond.
Should the Fed implement this open-ended approach, then the dollar could be expected to lose some further ground. In addition, it might help the single currency push on towards the 1.30 level.
