What the Heck Happened to the Dollar?!

After chillin’ like ice cream fillin’ for the past couple of days, the currency bulls and bears suddenly fired up and dragged the Greenback lower against its major counterparts. We saw EUR/USD jump by 96 pips to 1.3897, while USD/JPY plunged to a new post World War II low below 76.00. What are the possible reasons for the dramatic price action?

Risk appetite in markets

Could it be that the dollar simply fell on a round of risk appetite in markets? After all, what’s not to like about a combination of strong earnings reports from blue chip stocks, positive economic reports from Canada and the U.K., and an increased possibility of a solution to the euro zone debt crisis?

After spooking the markets early in the week, Germany’s Angela Merkel and France’s Sarkozy calmed the markets by implying that though they might not agree on some plans for the euro zone debt crisis, they are both committed to find one that works.

Risk sentiment was further lifted in the later trading sessions when the euro zone finance ministers started their own conference ahead of the bigger EZ-related meetings next week. Since the European debt crisis has taken center stage for many months now, the possibility of a concrete plan from European officials encouraged investors to buy high-yielding currencies.

Whispers of a QE3 from the Fed

Another possible explanation for the dollar’s dramatic plunge is the latest bout of rumors suggesting that the Fed might implement its QE3 sooner than analysts estimated.

Yesterday Federal Reserve Governor Daniel Tarullo took the spotlight and publicly called for the Fed to step up its game and resume its large-scale asset purchases (a.k.a. Quantitative Easing). Fed Vice Chairman Janet Yellen also supported the idea, adding that high unemployment and low economic growth continue to plague the U.S. economy.

While markets aren’t exactly surprised that a QE3 is still on the table, many had believed that the Fed will wait a while before actually implementing it. Just a couple of days ago, the positive NFP, CPI, and Beige book reports pointed to a decreased possibility of a QE3. But now that more and more officials are hinting at another round of asset-buying that would inevitably weaken the dollar, traders are taking their investments away from the Greenback.

Profit-taking ahead of next week’s events

While risk appetite and QE3 prospects are good candidates for the dollar’s plunge, could it be the other way around and traders are actually closing their open positions ahead of the potential market-moving events next week? Some technical traders believe that the high-yielding currencies were simply oversold, and that traders are taking off their short positions before the week ended.

Aside from the euro zone finance ministers’ meeting held last Friday, the finance ministers from all of the 27 EU countries will also have a big meeting this weekend. Between tomorrow and the bigger Economic Summit scheduled on Wednesday, we’ll probably hear more rumors and speculations that lead to choppy price action.

But it doesn’t stop there! Other big economic reports are also scheduled for release next week, including the BOJ, BOC, and RBNZ’s interest rate decisions, China’s HSBC manufacturing PMI, and the U.S. GDP report.

Whether the dollar’s fall was caused by one factor or the combination of all three, we can’t deny that yesterday’s strong move is the last that we’ll see in the next couple of days.

With more market-moving reports just around the corner, the important thing to remember is to stay flexible in your biases and to stick to your trading plan to avoid getting caught in the opposite side of a strong move.