What’s It Gonna Be, USD?

After three whole months, the Federal Reserve looks like it’s ready to bring out the big guns again. Recall that the Fed just launched QE3–also known as QE-4ever–in September, a program that involves purchasing $40 billion worth of mortgage-backed securities every month for an unspecified amount of time.

Now, market participants are projecting an additional $45 billion in asset purchases before the year ends. They believe that once Operation Twist expires on December 31, 2012, the Fed will have no choice but to fill the void that it leaves behind. After all, if the Fed allows Operation Twist to end without a replacement, the results of its previous QE efforts might just quickly fade away.

The $45 billion in purchases, dubbed “QE4,” is expected to complement the Fed’s $40 billion per month program to bring its total monthly purchases to a whopping $85 billion. Yes, you read that right… That’s more than double the Fed’s current balance sheet expansion rate! Just like QE3, market participants and other analysts think that the Operation Twist replacement program will be open-ended too.

Equally as important as its decision about asset purchases is the Fed’s outlook for the economy, as the Fed is also schedule to release its quarterly economic projections on Wednesday. Word on the grapevine is that there’s room for a bit of optimism, but I personally wouldn’t count on the Fed to change its forecasts.

Yes, we saw record Black Friday sales last month, which means that Hurricane Sandy didn’t completely wash away consumer confidence. And yes, November recorded surprisingly upbeat employment stats, as it delivered a better-than-expected jobs growth of 146,000 and a three-year low in the unemployment rate at 7.7%.

But as we know, one month does not a trend make, and it’s unlikely that the Fed will change its outlook significantly based on a single month’s worth of data. Besides, with the Fiscal Cliff raising serious threats to the economy in 2013, the Fed will likely want to remain cautious and refrain from being overly optimistic.

Potential impact on the dollar

USDX Chart

When it comes to gauging the effects of tomorrow’s FOMC statement on the dollar, there are three questions we need to answer:

1. By how much will the Fed increase its balance sheet funding?

Most believe that if the Fed doesn’t bump up its asset purchases by at least $45 billion a month, risk sentiment will turn sour and prop the dollar up.

2. What will comprise the Fed’s additional purchases?

The markets are looking for the Fed to spend $45 billion in treasuries alone, so such an announcement may not have a big market impact. If, however, the central bank decides to shell out dough for more mortgage-backed securities, it could catch the markets off-guard and possibly lead to a dollar rally.

3. Will the Fed revise its economic forecasts?

As for the Fed’s economic projections, upward revisions would likely lead to a risk rally, while downgrades could deal a blow to the market’s risk appetite.

Whatever the case may be, tomorrow’s big event could very well determine whether the dollar ends 2012 on a high or low note. Make sure you tune in at 5:30 pm GMT for the FOMC statement and at 7:00 pm GMT for the Fed’s economic forecasts.

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