A few weeks ago it was all but a done deal that the Federal Reserve would move forward with another round of Quantitative Easing, and Goldman Sachs released a report estimating that the Fed would have to print over $1 trillion for there to be any material change in the economy.  This is on top of the $2 trillion the Fed printed during the first round of QE at the outset of the 2008 Global Credit Crisis.  The magnitude of these numbers rattled investor sentiment toward the U.S. dollar and the market engaged in steep dollar selling during the month of Septemeber.  In fact, the U.S. Dollar Index was pretty much a one way slide to the downside during the month of September.
 Note: Past performance is not indicative of future results.
The thought of the Federal Reserve expanding its balance sheet by another $1 trillion did not go over well with investors during the month of September, and the dollar fell sharply as you can see in the chart above.  In the month of October, however, things began to slowly change.  During September and early October, QE was, as stated earlier, basically a done deal.  Federal Reserve Chairman Ben Bernanke was hinting toward further QE measures every time he spoke and the Federal Open Market Committee Report started offering strong clues that another round was coming soon.

In October, key economic data began showing signs of stabilization in the U.S. economy, and this caused investors to begin questioning whether the Federal Reserve really would go forward with another round of QE.  These investor doubts concerning further QE measures caused the dollar to rally in the 3rd week of October.  Mr. Bernanke gave a speech at the Fed Bank of Boston that week, and instead of outlining a specific plan for further QE measures, he simply laid out a case for why the Fed needed to implement them.  The market did not like this lack of clarity and took it as a sign that there was a slight possibility that QE Round 2 would not be as much as investors had initially priced in to the market; therefore, the dollar found support.

Now, for the last two weeks, the dollar has been showing some resilience against the Euro, Pound, Aussie, and New Zealand.  The Wall Street Journal printed a front-page story today, stating that the QE Round 2 will most likely be much lighter than first anticipated.  Current market expectations are that the Fed will go forward with another round, but it will only be an initial printing of $500 billion.  Since the market had priced in a much larger figure, there is now room for the dollar to gain strength in the near-term, and that is exactly what we are seeing.

In yesterday's analysis, we stated that the U.S. Dollar Index had formed a higher low on the Daily Chart, and it looked poised for a further bullish run.  This view has strengthened in today's market action.  If you look at the USDX chart above, you can see that today's candle is now pushing to break above the previous swing HI at 78.30.  A break above that previous swing HI should open up a path to the 80.00 level, which means we could see dollar strength for a few weeks.

Of course, further dollar strength will now be completely dependent on the Fed's decision next week.  On Wednesday, the Federal Reserve will be announcing interest rates and whether or not they will move forward with another round of QE:

Option #1
The market is widely expecting $500 billion of additional stimulus.  Then, the Fed will most likely leave further stimulus measures open-ended in order to see how this first $500 billion works out.  If the Fed makes this decision, then the dollar will most likely continue to find a bit of strength, and we may begin to slowly trickle lower on the EUR/USD and GBP/USD until the market finds strong support in the next few weeks.

Option #2
If the Fed decides to move forward with another round of QE at a pace of $1 trillion or higher, then the dollar will get absolutely slaughtered.  As we have stated, the entire reason the dollar has found this strength in recent weeks is due to the market beginning to price in the $500 billion package.  If the package does end up being $1 trillion, the euro and pound should be post new HI's on the Daily Chart, which means the euro could move well above the 1.4200 level and the pound above the 1.6000 level.

Option #3
If the Fed decides to hold off on another round of QE for another month or two, then the dollar should rise sharply, and we could see the euro back below the 1.3000 level and the pound below the 1.5000 level.  Remember, the entire run up on the euro and pound over the last several months has been largely on the basis of further QE measures from the Fed.  If these measures are not taken, then the dollar has plenty of ground to recover against most major currencies.

Key Economic Data

Key economic data out of the U.S. was mixed Wednesday with Core Durable Goods coming out worse than expected at -0.8% and New Home Sales coming out better than expected at 307k.  This mixed data is further evidence that the U.S. economy is not materially worsening.  In fact, the housing numbers were quite good-307k is the best number the market has seen since July.  Increased demand in the housing sector will be a major key to sustained recovery in the U.S., and this figure is a positive sign that there is some demand out there.

Thursday is light on economic data with HPI coming out of the U.K. and Unemployment Claims coming out of the U.S.  All eyes are now turned to Friday's GDP release, which has the potential to aggressively push the market in either direction.  A better than expected GDP figure will most likely push the dollar sharply higher as it will be further evidence that QE Round 2 may not be needed in the near-term.