Fed taper near certainty, dollar rally not

The economic and political hurdles for the U.S. Federal Reserve to taper its bond purchases are steadily being removed, making it almost a dead certainty – but don't expect it to necessarily spur a U.S. dollar (NYBOT:DXZ13) rally, at least not yet.

It appears Democrats and Republicans are closing in on a deal over the U.S. budget, which looks likely to avoid a confidence damaging shut-down of the U.S. government early next year. On the economic front the surprisingly strong U.S. jobs numbers last week and positive revisions to GDP are powerful incentives to start reining in the Fed's $85 billion a month bond purchasing program.

Given the level of debate over the Fed's taper it is unlikely to come as much of a surprise to anyone when it actually begins. In other words, the forex markets have largely priced it in. The only real question will be by how much. Given some reservations within the Fed, it will probably be relatively small initially, but could be announced as early as the Dec. 17-18 policy meeting.

However, Fed officials may delay the taper to sometime in Q1. Inflation numbers remain relatively benign and they may feel that they want more evidence that the economy really is improving. After all the Fed is targeting an unemployment rate of 6.5%, it's currently 7%. The low labor participation rate – at under 63% – is also a concern. It's at its lowest since 1978 and has been deteriorating. And this has negative implications for long-tern economic growth.

Growing confidence in EUR/USD             

A modest taper?

Given these mitigating factors, the Fed's quantitative easing program may well continue throughout next year and will only be reduced very gradually. That will of course depend on the strength of the U.S. economy. Any signs of economic weakness are likely to see the Fed pause the pace of the taper.

However, the outlook for the U.S. dollar also depends on what's happening with its trading partners. Japan remains committed to re-inflating its economy through massive stimulus measures, suggesting the outlook for JPY remains bearish and particularly so if perceptions of risk also diminish next year.

For EUR/USD the picture is more complicated. The European Central Bank has signaled that its monetary policy will remain very accommodative far into the future. It also sees downside risks for the world economy – not least from the Fed's taper. That's all bearish.

On the other hand, the Eurozone is inching toward a mechanism for rescuing struggling banks. Yet another factor is that peripheral Eurozone economies have shown improvements this year and that could be followed through into 2014. These two factors would be bullish for EUR and would eventually sway the ECB's monetary policy.  It also boosts confidence in the survival of the EUR.

The U.K. is closer to the U.S. in that it has a strengthening economy. The Bank of England has become increasingly hawkish. It has already withdrawn a special support scheme for mortgages. And has flagged its concerns over soaring real estate prices and stands by to pop any potential bubble if needed.

Nonetheless, the central bank wants to maintain an accommodative monetary policy to support consumer spending and business investment. For as long as the markets are not focusing on the U.K.'s huge current account deficit – the outlook for GBP/USD remains bullish.

About the Author
Justin Pugsley

Justin Pugsley is the forex and gold markets analyst for New Zealand-based trading platform provider MahiFX. He is a keen student of markets, economics and history. Prior to working with MahiFX, Justin worked for a number of leading media organisations such as Thomson-Reuters and Dow Jones/Wall Street Journal.

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