The #1 Threat to the Dollar Rally This Week

The dollar’s recent rampage could either gain momentum or come to an abrupt end this week when Fed Chairman Ben Bernanke testifies before Congress regarding the US economy and monetary policy.

Anyone watching the price action of currencies in recent months would know that the US dollar (USD) has been on a tear. Last week, the greenback rose to fresh four-year highs against the Japanese yen (JPY), a new one-month high against the euro (EUR), and an 11-month high against the Australian dollar (AUD).

On a trade-weighted basis as measured by the US dollar index, the greenback reached a three-year high last week, but the sustainability of the dollar rally against other major currencies will now hinge upon what happens this week.

Don't expect upcoming US economic reports to be game changers for the dollar, but what could affect dollar trade in a very big way is Fed Chairman Ben Bernanke's testimony and economic outlook, which is set for this Wednesday.

More: See the complete Economic Calendar

The relentless dollar rally indicates that investors are pricing in a major change in Fed policy, and Bernanke's comments could either support that position, or potentially bring the dollar rally to an end.

A number of Fed Presidents—though mostly non-voting Federal Open Market Committee (FOMC) members—have called on the Fed to scale back the amount of asset purchases as quickly as June. This is not the same as "tightening" monetary policy, but in the eyes of investors, it's a step closer to it.

If Bernanke drops even the smallest hint that the Fed could vary bond buying—either by talking about it directly, or by sounding more optimistic about the outlook for the US economy—the dollar could hit new highs. However, if he spends more time talking about the constraints in the US economy and the fiscal drag, the dollar could fall quickly and aggressively as speculators cut their long dollar positions after realizing that mapping an exit plan for quantitative easing (QE) doesn't mean that the Fed is ready to head that way.

When we last heard from the US central bank, policymakers said they were prepared to increase or decrease the size of the Fed’s monthly bond-buying program in response to changing economic conditions. Since then, we have seen record-breaking moves in the stock market, a jump in consumer confidence, and some mixed US economic data.

Job growth surprised to upside along with consumer spending, but the recovery in manufacturing is losing momentum. As one of the more dovish members of the FOMC, we expect Bernanke to be very careful with his choice of words. After seeing how the markets have responded to the prospects for diminished QE, we don't expect Bernanke to openly say that the economy has improved enough to warrant changes in monetary policy. Managing an exit won't be easy, and if anything, he will suggest that even if the Fed were to decrease asset purchases, they could increase them again if the economy weakens.

In other words, while we don't expect Bernanke to kill the dollar's rally intentionally, his caution could lead to profit taking.

Why Latest FOMC Minutes Could Mislead

The FOMC minutes also pose more downside than upside risk for the greenback because the meeting took place before the latest non-farm payrolls (NFP) report. The number the Fed most likely had on hand at the time of the meeting was 88k, and If you recall, payrolls for March were revised up from 88K to 138K and then increased to 165K in April, but we did not learn this information until two days after the FOMC announcement. Therefore, the tone at the last meeting could be more cautious with the doves screaming a little louder, which would not be good for the US dollar.

There are a number of Eurozone, UK, and Australian event risks this week as well that could play a role in how the EURUSD, AUDUSD, and GBPUSD trade, but we'll spend more time on those as the week progresses. In the meantime, the primary threat to the dollar this week will be Bernanke's testimony before the Joint Economic Committee, as well as the latest FOMC minutes.

Potential Price Targets for Major Dollar Pairs

If Bernanke continues to sound cautious like some other FOMC voters who spoke last week, profit taking could drive the dollar lower, making 1.28 in EURUSD short-term support and 103 in USDJPY a near-term top. If we are wrong, however, and Bernanke is on board with the idea of reducing asset purchases, expect USDJPY to hit 104.50 and possibly even 105, and the EURUSD could drop to 1.2700.

In the long run, we still expect more gains in the greenback relative to other currencies, but we acknowledge that Fed Chairman Bernanke poses the most realistic threat to the rally this week.

By Kathy Lien of BK Asset Management

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