Euro and US Dollar Traders on Edge Ahead of Critical FOMC Decision

Fundamental Forecast for Euro: Bullish

• Euro poised to test fresh highs as sentiment still one-sided

• US Dollar suffers major break against the Euro – is it fatal?

• Euro traders eye potentially significant OMT decision as key risk

The Euro finished higher against the US Dollar for the fourth-consecutive trading week, good for its largest win streak since September and leaving it poised to test fresh peaks. A critical US Federal Open Market Committee rate decision in the week ahead looms large for all US Dollar pairs, but it might take a big surprise to allow the Dow Jones FXCM Dollar Index (ticker: USDOLLAR) to recover from its recent sell-off.

Traders headed into last week still net-short the Euro versus the US Dollar, and broader market sentiment suggests that the Euro may continue higher as traders unwind USD-long positions. But further Greenback losses and Euro gains aren’t foregone conclusions—particularly as the US Fed is set to deliver a potentially pivotal interest rate decision on Wednesday afternoon.

Event risk for the Euro Zone is comparatively limited, but it will be important to watch for surprises from the German Constitutional Court ruling on the legality of the European bailout plan. German ZEW investor sentiment data and PMI figures could likewise spark short-term moves, but it might take some especially-large surprises to distract traders from much-larger market themes.

The key theme/phrase in markets through recent price action has undeniably been “taper”. In short: when will the Federal Reserve begin to “taper” its aggressive Quantitative Easing policies and bond purchases? (What is the taper and why does it matter?)

Though it seems exceedingly unlikely that Chairman Ben Bernanke will announce a cut in QE on Wednesday, traders will watch for every clue on when the Fed might cut back on asset purchases. Why?

The US Federal Reserve has led global central banks in unconventional monetary policy easing on an unprecedented scale, and financial markets have seen similarly historic improvements on said policies. Even the thought that the Fed could soon slow its purchases has sent a chill down investors’ spines. No one wants to be the last one out of the “QE trade”, and we’ve seen some panic-driven sell-offs in the S&P 500 and even US Treasury markets as speculators charge for the exits.

Bernanke knows all of this of course, and it seems unlikely that the FOMC statement shows an especially hawkish shift in rhetoric. But recent market reactions to relatively insignificant data prints suggest the Fed doesn’t have to show a big shift. Markets are on edge, and the FOMC statement could be a game-changer.

How all of this plays out will likely determine Dollar direction versus the Euro and other pairs through the foreseeable future. Though it seems counterintuitive at first glance, we believe that the USD might actually decline if we see big sell-offs in the S&P 500 and Treasuries. Why? That’s exactly what’s happened in the past three weeks, and that’s because speculators remain heavily long the US Dollar.

Indiscriminate market deleveraging would likely force traders out of USD-long positions and might actually benefit the EURUSD. That isn’t our base case projection, but it’s certainly possible and traders should be aware of said risk.

Watch for surprises out of the Fed and lower-tier event risk from the Euro Zone. Forex volatility prices are at their highest levels on the year, but the past several years show us that markets could become much more volatile. - DR

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