It is FOMC day and while I’m flying off to the Bahamas this morning to celebrate my 1 year wedding anniversary (I’ll still be writing, just one piece a day!), I thought it would be worthwhile to resend my FOMC Preview.

With the number of unanswered questions it should be a very interesting day in the FX market and we expect the dollar and currencies in general to react to the whatever the FOMC decides.

Also it is that time of the year again when we have an expanded version of the FOMC announcement and here is the schedule:

12:30pm ET FOMC Statement released
2:00pm ET Updated Fed Forecasts
2:15pm ET Bernanke Press Conference

Lets look at each one of these events to see how they can impact currencies.

FOMC Statement – Look for New Program to Replace Operation Twist

– Extending Operation Twist is Not an Option
– Fed to Replace Operation Twist with $45B in Treasury Purchases
– Decision will Show Up First in FOMC Statement

Timing is the main reason why this month’s FOMC meeting has received so much attention. Operation Twist comes to an end on December 31st and unless the Fed wants to let a significant amount of stimulus instantly evaporate they will announce fresh measures to keep the party going. With the Fiscal Cliff still in the background and the talks going no where, the Fed will want to keep every ounce of their existing stimulus in place in case Congress cannot agree to a reasonable plan by the end of the year. By making major changes to monetary policy at these special quarterly meetings, Bernanke also has the opportunity to provide further details with the hope of minimizing volatility in the market.

Operation Twist was announced in September 2011 with the initial details outlined in the FOMC statement. While they may like to do so, extending the Twist is not an option because the Fed is running out of short term Treasuries to sell. Instead, it is widely believed that the Fed will replace OT with an open-ended commitment to buy $45B in Treasuries every month, bringing their total monthly purchases to $85B ($40B is currently spent per month on Mortgage Backed Securities). This decision will show up first in the FOMC statement as it did in September 2011, giving investors the opportunity to react immediately. Since most investors and economists expect the Fed to convert Operation Twist into additional Treasury purchases, there are 3 main questions that we will be looking for answers to in the FOMC statement:

3 Key Questions on the New Program:

1) Amount of Treasury Purchases – $45B is expected but will it be more or less?
2) What will be the Mix of Assets Purchases – $45B in Treasuries and $40B in MBS is expected
3) Will the Program have an Expiration Date like Operation Twist or be Open Ended?

If all $45B is spent in Treasuries, the impact on the dollar may be more muted. A decision to spend more on MBS and less on Treasuries would be a bit of surprise and could drive the dollar higher as bond yields increase. Some members of the Fed have felt that MBS purchases are more effective than Treasury purchases. An open-ended program will be more negative for the dollar than a program with an expiration date like Operation Twist. However at the end of the day, even if the Fed announces an open ended commitment to buy $45B a month in Treasuries, without sales in the front end of the curve, the overall program should be more stimulative for the financial markets and risk currencies while being more negative for the dollar.

Fed Forecasts – Looking for Some Cautious Optimism

As shown in the table below, there have been both improvements and deterioration in the U.S. economy since the last FOMC meeting in October. Service sector and manufacturing sector activity slowed but the unemployment rate declined to 7.7% and non-farm payrolls grew by 146K last month, a sign that Superstorm Sandy’s bark was bigger than her bite. The latest retail sales numbers won’t be released until after the FOMC meeting but record sales on Black Friday and Cyber Monday suggests that consumer spending rebounded in the month of November. Based on these improvements, the Fed could leave its forecasts unchanged but with Fiscal Cliff uncertainty posing a significant risk to growth in 2013, they could also downgrade their 2013 forecasts but in all likelihood, their forecasts will most likely remain unchanged. Any upgrades will be positive for risk currencies like the EUR/USD, AUD/USD and USD/JPY while any downgrades should be negative for these same pairs.

Compare this week’s Forecasts with the Fed’s September estimates:

Bernanke Press Conference – Watch for any Skepticism

Fed Chairman Ben Bernanke’s press conference is where things can get more interesting as he will be peppered with questions on the economy, monetary policy and potential impact of the Fiscal Cliff. We’ll be particularly interested in seeing if he drops clues on the chance of the Fed targeting the unemployment rate. Central bankers have admitted that their forecast of interest rates is ineffective and the lack of price pressures has degraded the significance of an inflation target. Adopting an unemployment rate target would be far more powerful and transparent but it won’t come easy given the division within the central bank. In the past, Bernanke’s tone has also deviated from the Fed’s forecasts so if he expresses skepticism about the recent improvement in the unemployment rate, risk appetite could suffer.

While a change in monetary policy and additional asset purchases are widely expected, there’s enough wild cards in Wednesday’s announcements to drive up volatility in the forex market.