FOMC's stunning announcement yesterday that it will buy up to $300 Billion in Treasury bonds took the currency market by surprise and rallied the EUR/USD by more than 500 points in less than 24 hours. As we wrote earlier the FOMC announcement ,” represents an 'all-in' bet on massive monetary stimulus in order to stem the worst contraction in the US economy since World War II. The move is of course wildly dilutive to the currency with nearly $1 Trillion created out of thin air. Little wonder then why the dollar collapsed across the board even as other asset classes rallied. It also indicates that the Fed may have come to the conclusion that the two biggest customers for US debt – China and Japan – may be unable or unwilling to provide additional capital to finance the gargantuan expansion of US fiscal spending this year and next.”

The Federal Reserve has previously promised to use all available tools to help the U.S. economy recover and they have followed through with that promise. The U.S. central bank has officially cranked up the printing presses and will be flooding the financial markets with money.

The pound lost more than 200 points by early London trade after the currency came under assault on multiple fronts as the economic fundamentals of the UK economy deteriorated further, UK jobless rolls swelled by 138.4K versus expectations of 84.5K as the overall unemployment number crossed the critical 2 Million mark. The claimant count rate increased by 4.3% versus 4.0% forecast while average earnings including bonus dropped from 3.2% the month prior to 1.8% in January. Additionally the unit was hurt by an earlier report from IMF that suggested UK recession could last well into 2010.

A bank report that we read this week had an interesting line summarizing investors’ attitude towards the U.S. dollar over the past few months. They said that being long dollars means being long pessimism and we believe that this is a valid description of the recent price action in the currency markets. Today, the dollar weakened against every major currency except for the Japanese Yen. This weakness as baffling as it may seem is more of reflection of the market’s optimism than pessimism because equities are higher and gold prices are lower.

The Federal Reserve has officially run out of room to cut interest rates. For the first time since August 2007, they left interest rates unchanged at a target range of 0 to 0.25 percent. The dollar rallied because the Fed did the minimum of what was needed to pacify the market, which was to say that they could purchases Treasuries but are not going to do so right now. Currency traders were looking for something more radical such as inflation targeting or a bold announcement that they start buying long term Treasuries in size - which would have been dollar bearish. Interest rates could remain at current levels for the next six months as the central bank focuses on credit easing. The Federal Reserve was pessimistic about the outlook for the US economy and said that inflation could continue to remain weak in the coming quarters.

The Federal Reserve is currently holding a two day monetary policy meeting and it will be interesting to see whether they are desperate enough to introduce radical programs that can incite the enthusiasm of investors. With interest rates virtually at zero, a rate cut is not expected, but the central bank is under pressure to take further action. So far, their effort which includes 500bp of easing has helped to prevent the recession from turning into a depression but it has yet to stabilize the economy. The latest string of economic data indicates that the US economy is still on a downtrend and headed lower. The FOMC rate decision tomorrow could be a nonevent for the US dollar, but if the Federal Reserve is desperate enough, they still have the power to surprise the markets.

The US dollar continues to rise, but the rally is tempering. After sharp losses this past week, the Euro, Japanese Yen and Australian dollar are beginning to stabilize against the greenback. US equities have been in the red throughout the day, which is why most currencies remained negative despite sharp intraday reversals. Over the next week, the US dollar faces 3 big threats that all traders and investors should be aware of – a bad bank plan, central bank intervention and economic data:

Tuesday’s FOMC meeting will be remembered for decades to come as the Federal Reserve brings interest rates down to the lowest level this generation has ever seen. With 2 realistic options on the table and economist and traders divided on how much the Fed will cut interest rates, the only certain outcome is significant volatility for the currency market. No matter how you look at it, an interest rate of 0.50 percent is just as unattractive as an interest rate of 0.25 percent.