Even neutral news from the Fed will boost the greenback

FEDERAL RESERVE Chairman Ben Bernanke and the rest of the Federal Open Market Committee (FOMC) have an unenviable job today as they discuss the next steps for US monetary policy against the backdrop of improving global conditions &ndash; the decision is due at 7.15pm this evening<br /><br />Since the committee last met on 28-29 April, the world&rsquo;s economic and financial conditions have improved substantially. A recovery, however nascent, is looking more and more likely and what was considered a dead cat bounce in April has since proved a sustained market rally.<br /><br />But the FOMC has a difficult line to tread. The improvement in economic conditions in the US and other economies has been evident from a number of indicators, including unemployment rising less sharply than it has, and a slowdown in the pace of contraction in manufacturing. The feeling that the worst is now behind us has raised the possibility of a small interest rate rise by the FOMC, probably in the first quarter of 2010 &ndash; Federal funds futures contracts are now starting to price in such a rate increase and this has already boosted the dollar.<br /><br />However, with GDP still contracting, tight credit conditions continuing and unemployment expected to go on rising into 2010, the FOMC will be loathe to increase interest rates any sooner than is necessary.<br /><br /><strong>EXCEPTIONALLY LOW</strong><br />ING economist Rob Carnell says that he believes the Fed could keep rates extremely low right through 2010. He believes that the statement which will accompany the Fed&rsquo;s decision will again argue that &ldquo;economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended time&rdquo;. <br /><br />But the FOMC&rsquo;s room for manoeuvre is constrained by stubbornly rising Treasury yields, which will impede the strength of any recovery. Rates on longer-term Treasuries have increased by about 140 basis points since mid-March when the US quantitative easing (QE) was announced.<br /><br />The Fed will be keen to cap the rise in bond yields and one way it could do this is by signalling that it has no intention to raise rates in the short term while providing optimism on the recent improvements in data. George Tchetvertakov, head of market research at Alpari (UK), says: &ldquo;The Fed will only want to increase its QE programme beyond the current level if yields go beyond the current 4 per cent.&rdquo; <br /><br />The tone of the announcement should be eagerly awaited by foreign exchange traders looking for the inevitable dollar moves.<br /><br />A very optimistic statement will increase the chances of a hike in interest rates, which ought to prove very dollar positive. But if it is negative then that could mean further expectations of QE. The US Treasury &pound;104bn auction over the next three days will be crucial in determining how much confidence the market has in the US as a place to invest and could have as much of an impact as the Fed on the dollar.<br /><br /><strong>RISK AVERSION</strong><br />Tchetvertakov says: &ldquo;If you look at the current speculation then it looks like people are thinking that it will be quite a negative statement &ndash; earlier this week there was a return towards risk aversion. So even if the statement is in the middle then that could be seen as quite positive by the market and boost the dollar.&rdquo; <br /><br />However, while a middling-to-positive statement from the Fed will lift the dollar, it could damage the dollar&rsquo;s upside prospects over the next week to a month because it will encourage risk appetite, disadvantaging safe havens like the US dollar against risky currencies such as the Australian dollar.<br /><br />Whatever comes out of the Fed there is bound to be volatility in the currency markets ahead of the decision, which can only be good news for the forex trader.