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Expect Dollar Gains on Diverging Fed Policy

Richard Cox

NEW YORK (TheStreet) -- The dollar has been under pressure this month against both the yen and the euro, as monetary policy meetings have failed to produce suggestions of additional stimulus in Japan or Europe.

The latest example of this was seen with this week's Bank of Japan interest rate decision, where voting members chose not to extend maturities on bank loans or to make alterations to the bank's annual plans to inject 60 trillion yen ($610 billion) into Japan's monetary base.

The yen rallied after the meeting, as a cross section of the market was expecting the central bank to enact measures to reduce volatility in Japanese bonds.

Moves like this in the yen are likely to occur any time markets perceive the Bank of Japan as being unable to reign in bond yields or ineffective in implementing a sustainable strategy to drive economic growth.

The yield on the 10-year Japanese government bond had risen from its all-time low of 0.315% to 1% after the Bank of Japan announced its historic stimulus program (which doubled monthly bond purchases).

But at the June meeting, a more conservative bias was voiced, and the lack of additional policy easing has led to extreme selling pressure in the Nikkei 225 and rallies in the yen (to more than 94 vs. the dollar). This month's moves have been massive, and valuations are now approaching levels seen when the Bank of Japan's stimulus programs were originally announced.

Diverging Central Bank Policies

Similar results were seen at the latest policy meeting at the European Central Bank, as interest rates were left unchanged at 0.5%. The market's reaction was to push the euro higher, based largely on the suggestion that the ECB sees no immediate need to implement negative deposit rates.

Buying in currency pairs such as the EUR/USD added to the downward pressure on the dollar, helping define this month's broader theme to sell the U.S. currency.

So, the main question investors should be asking is whether these moves are sustainable. Both the Bank of Japan and European Central Bank are in relatively early phases of their current stimulus programs when compared with the Federal Reserve.

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).

June's bearish moves in the dollar should be viewed as a buying opportunity. By the end of the year, the currency will be higher, supported by the diverging central bank policies that can be seen in the Bank of Japan, European Central Bank and Federal Reserve.

At the time of publication, Cox had no positions in stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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