How Bernanke Crushed the Greenback

After ranging around the 80.00 handle for the past few days, the U.S. Dollar Index, which measures the dollar against a basket of currencies, finally broke down and closed around its monthly low at 79.36.

US Dollar Index

Meanwhile, EUR/USD pared most of its losses and skyrocketed past the 1.3300 handle despite lingering concerns about the debt crisis. Equities also recouped a week’s worth of losses as DJIA rose by 1.2%, S&P 500 jumped by 1.4%, and Nasdaq spiked by 1.8%.

These drastic moves that we saw across markets yesterday were caused by none other than Fed Chairman Ben Bernanke. In a speech at the National Association for Business Economics Annual Conference, the Fed head honcho surprised markets by saying that more stimulus could be necessary to support the economy. This caught many investors off-guard as his remarks reflect a different tone from the most recent FOMC statement which emphasized the improvements in the U.S. economy.

To understand why, you need to know that the central bank has always been focused on keeping bond yields low. However, this hasn’t been the case of late. 10-year Treasury yields actually spiked up to 2.93% recently and prompted Bernanke to shift his stance. He reiterated that monetary policy will remain loose for some time and slashed hopes that the Fed would hike rates in 2013.

Another reason explaining Big Ben’s sudden shift to a more dovish stance is the state of the U.S. labor market. Although the jobless rate improved from 9% to 8.3% over the last six months, the Fed head is still worried about the fact that a considerably large number of people have been out of work for more than half a year. He also pointed out that the drop in joblessness was merely a reversal of the massive layoffs seen since the recession.

Since faster hiring and further declines in unemployment could be spurred by rapid economic growth, Bernanke believes that an extra shot of stimulus to the U.S. economy is the way to go. This way, the Fed could more or less guarantee that the recent improvements in the jobs market could follow through.

With the prospect of further easing aimed at sustaining hiring and growth, investors were reminded how this type of monetary policy was eventually able to lift U.S. stocks out of the bear market after the recession. This explains why we witnessed a strong risk rally during Bernanke’s testimony, despite his downbeat tone.

Some economic analysts even pointed out that Bernanke’s openness to further QE was enough to assure market participants that the Fed was ready to print more money as soon as signs of weaknesses pop back up. Because this highlighted the fact that the central bank was intent on preventing another economic slowdown from happening, traders didn’t feel so hesitant to take on more risk.

Aside from that, the promise of low U.S. interest rates for an extended period of time meant larger interest rate differentials, triggering a rally for the higher-yielding currencies as traders took advantage of carry trades. Whether these risk rallies would last or not still remains to be seen as other major economies are also fighting their own battles, but it’s pretty clear that the Fed is ready to do anything just to keep the U.S. economy on its feet.