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Expect Dollar Gains on Diverging Fed Policy

The next Fed meeting will take place on June 18-19, and most of the market's attention is focused on the possibility that the central bank will cut back on its purchases of Treasuries and mortgage-backed securities (which currently total $85 billion each month).

If we do see explicit changes in Fed policy, they will signal a major turning point for the dollar. Since the Fed began quantitative easing in 2008, the U.S. Dollar Index (which tracks the currency's value against the euro, yen, pound, Swiss franc, Canadian dollar, and krona) has dropped by roughly 8%. A change in policy stance will lead to reversals in valuation trends (and a stronger dollar).

Long-term bond rates already show that the market has started to price in Fed tapering, with 10-year U.S. Treasury yields now near 2.2%. By historical standards, this is relatively low but still a marked increase from the 1.6% seen in early May. Longer term, currency values will typically move in line with bond rates, so the bearish June moves in the dollar are starting to look transitional and temporary in nature.

Current Weakness Signals Buying Opportunity

It is unlikely that the Fed will pull back on quantitative easing at next week's policy meeting. But recent comments from the central bank indicate that stimulus programs are ready to be phased out. Once this policy change is made official, long-term rates should rise and the value of the U.S. dollar should follow suit. This essentially means that this month's moves in currency markets are little more than knee-jerk reactions to short-term events (disappointing results from monetary policy meetings in Japan and the eurozone).

Recent weakness in the dollar does not match long-term fundamentals, as the economy continues to show gradual expansion. It should be remembered that average monthly job gains so far this year have been less than 190,000, and that number is skewed by the 332,000 increase in February. But with improvements in the housing market and consumer spending, the broader trends are clear, and central bank commentaries continue to hint at the reduction of quantitative easing (a strong positive for the currency).
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