As a guide to the dollar's likely direction after the completion of the so-called QE2 programme, it may be worth looking at what happened after the Fed's first phase of quantitative easing ended in 2010.
In April 2010 the U.S. central bank was in the process of unwinding some liquidity measures and the dollar embarked on a rally of nearly 10 percent that only came undone when the Fed subsequently highlighted its concerns over a softening of the economy at its June meeting.
All of the dollar's April-June gains were unwound by the time the Federal Reserve decided to re-invest the proceeds of maturing mortgage backed securities or agency debt into longer-term Treasury securities in August.
The dollar had dropped a further 10 percent in value by the time the U.S. central bank implemented QE2 last November.
The Dow Jones index tells a similar story, dropping almost 1,750 points between April and June and then regaining all this ground by the time of QE2 and rallying by another 1,000 ticks to reach today's level.
The dollar has traded in a somewhat similar way in recent weeks with the end of QE2 this month preceded by intense speculation about the possibility of the central bank tightening monetary policy, and how this will be done.
The dollar index rose more than 5 percent between May 4 and 23 as few in the market were willing to consider that the U.S. central bank could launch a third round of asset purchases.
There was far more speculation about asset sales than any expectation that the size of the Fed's balance sheet could be maintained at its current size.
During this period speculators wound down bets that the dollar would fall and the Dow Jones index dropped around 5.5 percent.
Dollar shorts are now around $15 billion, less than half the $35 billion at the end of April and equity traders have adopted a much more defensive stance by switching into cash or bonds.
Although economists have pared expectations for U.S. growth since last Friday's May payrolls data, there is still almost no expectation for the Fed to embark on QE3
That said, the consistent pattern of weak U.S. economic data has finally steered thinking away from possible monetary tightening towards a view that the U.S. authorities will want to see how the economy develops after QE2 has run its course.
In effect this is the same policy that guided the U.S dollar lower after August 2010, and given the dollar's downward trajectory between August and November last year, it may be prudent to position for a weaker dollar again, especially as there is clear evidence that speculators are no longer running significantly short of the U.S. currency.
On the other hand, it is notable that beyond one month, economists still see the dollar higher with euro/dollar seen back down to $1.4500 in three months and $1.4100 by the end of this year
Such an outlook is out of kilter with interest rate expectations as 50 basis points of euro zone rate hikes are priced in this year. On the other hand no Fed tightening is envisaged before the first quarter of 2012.
Despite the recent weakness of U.S. data and the subsequent decline in the dollar, that has seen the dollar index drop 4 percent in less than two weeks, the positioning data suggests currency traders are ill-prepared for a further and potentially sharp fall in the value of the greenback.
A key break to an all-time low for the dollar index is only 4 percent from current market levels and a break above $1.5000 for the euro is less than 3 percent away. Euro longs are barely one fifth of the size seen when euro/dollar last closed on $1.5000 in April.
Judged by trade after August 2010 when the Fed last opted to maintain the level of its balance sheet, the dollar should head lower.
However, as economists still looking for a higher dollar, and traders not overly short of the U.S currency, any further shift in expectations towards easier Fed policy could bring with it a much faster fall in the greenback's value.
Copyright Reuters, 2011