The Federal Reserve announced Wednesday that it would purchase $300 billion of long-term Treasurys over the next six months. Called "quantitative easing," the program is designed to lower borrowing costs for consumers and get credit flowing more freely again.
But the decision to buy up massive amounts of government bonds sent Treasury yields lower, as prices move in the opposite direction of interest rates. As yields fall, U.S. assets become less attractive to foreign investors, leading to a decline in the dollar relative to other currencies.
"Usually, one of the things that supports a currency is the nation's benchmark bond yield," said Antonio Sousa, senior currency strategist at Forex Capital Markets. "People no longer want assets in dollars because the yield is so small."
Accordingly, the euro gained 1.5%, hitting a fresh 2-month high against the dollar. The 16-nation currency traded at $1.3676, up from $1.3474 late Wednesday.
The British pound bought $1.4525, up 1.8% from $1.4272, and the dollar sank against the Japanese yen, falling 2.2% to ¥94.06 from ¥96.23.
Currencies soared against the dollar Wednesday, with the dollar falling by more than 3% against the euro, the largest decline in nine years.
Experts are divided about how long the dollar will trend downward for, though they agree that it will be some time until a recovery can occur.
"Looking forward, the greenback probably will weaken further, at least in the near term, versus most other major currencies," said Jay Bryson, global economist at Wachovia, in a note to investors.
Bryson sees the euro gaining to about $1.39 and the pound moving higher to $1.45 in the next week or two, but argued that a long-term plunge may not be in the cards, as other central banks may be enticed to join into the quantitative easing game.
"Although the greenback will probably depreciate further in the near term, it is not entirely clear that the dollar longer-term trend is down," Bryson said. "If the European Central Bank engages in its own version of 'quantitative easing,' then the euro could give up the gains it has racked up over the past few days."
But Sousa said that the sheer length of the Fed program -- six months of buying up bonds -- will drive down traders' sentiment about the dollar for at least that long.
"We're not going to get out of this environment in 2009," Sousa said. "People are looking forward to 2010."
The Fed said in its statement it believes that inflation would remain "subdued," expressing more concern about deflation, in which falling prices lead businesses to further cut their output and employment.
In its statement Wednesday, the Fed said it "sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."
Sousa said that will be bad for the dollar, because the U.S. currency also depends on relative strength of the stock market.
"Stocks won't perform well in a deflationary environment, because companies will be forced to cut prices, which will ultimately drive profits lower," Sousa said. "Treasurys aren't the only factor that matters - another thing that drives performance of currencies is the performance of assets in those currencies."
Furthermore, Treasury yields sank sharply after the Fed's announcement to levels not seen since December - when the last stock market rally ended and market indexes plunged to 12-year lows. A similar drop in stocks this time around could hurt the U.S. currency's chances of rebounding, according to Sousa.
Still, much of the dollar rally that has continued almost uninterrupted since the summer has been based on investors' bets that the U.S. economy will be the first to recover among its peers. Bryson said the dollar may rise in the long term if traders believe the Fed's actions hasten an economic recovery.
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