Extending the Extended

Y’all are probably wondering what happened last Friday, when the greenback got a major beating across the board. At first glance, it would seem that the sell-off was merely caused by risk appetite, when the US retail sales report beat expectations by a large margin.

Sure, risk appetite had a significant hand in price action, but something else was at work. And here is where I come in. As usual, whenever you need the latest news on the forex markets, trust FX guru (well, not really) Forex Gump to give you the lowdown.

Last Friday, President Barrack Obama picked out Janet Yellen as his preferred choice to be the Federal Reserve‘s new Vice Chairman. This was taken as a sign by currency traders that interest rates in the US will remain ultra-low all throughout 2010 and 2011, causing a drop in sentiment towards the dollar.

Generally, the prospect of low interest rates discourages investment in a country (in this case, the US), and causes investors to search elsewhere for yield. As a result, demand for their currency falters, making it less valuable relative to other currencies.

You may be asking who the heck is Janet Yellen?

Currently, Yellen is the head of the San Francisco Federal Reserve Bank. More importantly, she is considered to be the most dovish amongst the Fed members, which means that Yellen is more in favor of keeping interest rates low in the near future. In fact, in a recent interview, she said that if it were possible to make interest rates negative, she would!

It seems that Yellen is a cynic, and believes that the current run of good economic data is merely reflective of the government programs that were implemented in response to the financial meltdown. She believes that inflation is too low, unemployment too high and the prospect of economic growth dim. Yellen believes that the economy still needs mores stimulus in order to regain its bearings.

Now, traders are curious how Yellen could influence the Fed’s decisions and this week’s FOMC statement could show just that. Although the central bank is expected to keep interest rates at their current levels, would they go on to say that this extended period of low interest rates could be further, uhmm, extended? After all, Yellen has been quoted saying that it’s not entirely impossible for rates to stay near zero for the next couple of years. Uh-oh…

If the rest of the Fed officials side with Yellen in confirming that a longer period of low interest rates is warranted, the greenback could suffer another round of losses, possibly for the entire week.

On the other hand, if the policymakers decide to highlight the recent improvements in the US economy, such as employment and retail sales, the greenback could possibly stay afloat. Recall that Bernanke and his boys have already implemented a pseudo-rate hike by raising the discount rate, a move considered by most traders as a sign that an exit strategy is on the horizon.

I guess we’ll just have to wait and see what the Fed says tomorrow!