If the Grinch Takes a Stock Rally, Can Santa Rally FX?

As the Federal Reserve started their end of the year meeting on Tuesday, the stock market produced a slight drop due to speculative fears of a taper of QE3.  The long awaited news of a potential taper will be announced today, concluding the Fed's meeting.

What to expect from the taper?
We can expect to see risk-on-risk-off trading. Investors will start to liquidate riskier assets such as equities and risk driven currencies causing them to depreciate. Investors will want gravitate towards lower risk investments and currencies such as the US Dollar. The result is a bearish correction in the equities market, with a surge of demand towards safe-haven assets and currencies such as the US Dollar.

Looking at the daily chart below we can see how the US Dollar began appreciating due to mentions of a taper in mid October.

US Dollar Index
Daily Chart

Forex Outlook
If we analyze the current and future monetary policies of both the United States and Japan, we will see that the policies are taking two opposite directions. The Federal Reserve is looking to cut down on it's stimulus package, decreasing the purchases of mortgage securities and treasury bonds, while the Bank of Japan is try to boost growth through increasing their stimulus buyback programs.
After looking at the different directions the policies are taking, we can now conclude that the currencies shall react in a similar manner. As our Federal Reserve cuts down on money flow into the economy, the US Dollar will be higher in demand, therefore increase in value. As more of the Japanese Yen flows into their economy, the demand for the currency shall decrease, therefore depreciating the currency.

Below we can see how the two differing policies affecting the currency pair price. The most recent rally began in October with just talks of a taper. If the Fed decides on implementing a taper we can expect a continuation of this rally.

USD/JPY
Daily Chart

What is the Taper, and How Does it Effect my Trading?

Fears of high volatility and price corrections in the Forex, equities, and bond markets are due to the recent "Taper" speculation set in by Fed Chairman Ben Bernanke. You ask, what is "Tapering" and why is it important? Tapering refers to the method used by the Fed to gradually decrease their monthly purchases in their recent stimulus buyback program, better known as quantitative easing (QE3). QE3 started back in the Fall of 2012, allowing the Fed to purchase $85 billion in Treasury Bonds and Mortgage Backed Securities. The purpose of this stimulus package is to promote growth in the economy by lowering interests rates.

Looking at the markets performance over the past year we can see how QE3 effected the equities.

With the Fed pumping US Dollars into the economy, the market became more comfortable with risk in equities causing this bullish uptrend and high returns. However with a possible "Tapering" ahead, we can assume that a significant correction to the downside may come. As the Fed gradually decreases the supply of US Dollars, investors will want to hold more dollars, causing an increase in demand for US Dollars with a decrease in demand in the equities market. For the Forex market, the USD will play a pivotal role in the speculation. Theoretically we can expect a spike in the USD due to speculation of decrease the supply of US Dollars in the economy (tapering).

Speculators are predicting for tapering to start in the Q1 of 2014. Therefore expect prices to correct themselves now for the events expected to happen later.