From the September 2013 issue of Futures Magazine • Subscribe!

Fed tapering and U.S. dollar potential

When the U.S. Federal Reserve embarked upon the policy of asset purchases (known as “Quantitative Easing”) in the wake of the 2008 credit freeze, the goal was to stimulate the economy by keeping longer term interest rates low.  This is accomplished by creating new money that increases the supply available.

If a strong economic recovery takes hold, this new money looks for a home and immediately can be sold into other assets or investments. This would weaken the purchasing power of the U.S. dollar (USD). Therefore, for the past five years, traders have grown accustomed to translating quantitative easing into representing a weaker USD.

Beginning in May 2013, the Fed communicated more purposefully to the markets the potential for tapering its purchases.  The exact amount of the taper, along with when the initial taper might happen, hasn’t been announced yet, but economists are forecasting it will occur in September 2013.  

If the Fed follows through with this plan, there are several reasons for future strength in the greenback.  Some of the reasons are exclusive of one another, so don’t look for all of them to occur.  Rather, look for at least one of these reasons to fuel a USD rally:

  • If USD weakens on increased money printing, then it makes sense for the opposite to occur, and we would see strength of the USD on reduced quantities of new money.
  • If tapering releases the headwinds and interest rates rise within the context of a stable U.S. economy, then capital may be attracted toward the U.S. currency.
  • If tapering increases rates, the higher rates may act like a tax on income and upset capital markets.  Money then looks for safety that is found in the USD.

U.S. dollar bottom

We will use the Dow Jones-FXCM Dollar Index (ticker: USDOLLAR) in our forecast, which reflects the change in value of the U.S dollar measured against a basket of the most liquid currencies in the world. The index is built by equally weighting of the following currency pairs: EUR/USD, GBP/USD, USD/JPY and AUD/USD. Together, this basket typically accounts for 80% of world-wide currency spot market activity and reflects a diverse economic and geopolitical make-up. 

Using technical analysis, we can see USDOLLAR has been hitting a series of higher highs and higher lows. The U.S. dollar already met the definition of an uptrend before the formalized taper plan was announced. 

In fact, the USDOLLAR carved out its bottom in August 2011, nearly two years ago (see “Taper talks,” below). So not only did the USDOLLAR uptrend begin before the taper plan was formalized, the uptrend began before the announcements of QE3 and QE4.  [Note: The U.S. Dollar Index bottomed in 2009.]

This is what we find most compelling because the USDOLLAR was showing relative strength when it had every reason to be weak.  Think of it like pressing down on a spring.  Once you remove your thumb, the spring explodes higher.  In this example, the USDOLLAR is the spring and the Fed’s asset purchases are the thumb. If the asset purchases get smaller, it would be like taking your thumb off a compressed spring.

How do you trade this?

Naturally, we want to look for technical opportunities to buy the greenback.  In forex, trades are made in pairs, so if we buy the USD, then we need to look for a weak currency to match it against simultaneously.

If the taper results in increased interest rates in the United States and a stable environment, then look for other low yielding currencies to match it against.  This way, you can earn a daily dividend by holding the trade open at 5 p.m. each business day.

At of the time of this writing, the euro (EUR), Swiss franc (CHF) and Japanese yen (JPY) are the major currencies that you can buy the USD against and earn a daily dividend. 

Therefore, enter trades toward USD strength by selling the EUR/USD pair or buying the USD/CHF and USD/JPY pairs.

If the Fed taper results in increased interest rates but in a risk-off environment, then consider the USD against other higher yielding currencies like the British pound (GBP) or Australian dollar (AUD).  That would mean selling the GBP/USD or AUD/USD pairs.

Jeremy is an active trader and head of DailyFX education of FXCM. He currently specializes in FX and writes education/analysis articles. 

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