Following some downbeat comments from the San Francisco Federal Reserve, there are expectations that the Federal Open Market Committee could move for more easing when it meets Tuesday.
"There is huge pressure on (Federal Reserve Chairman) Ben Bernanke to do something," said Mark O'ullivan, a director Currencies Direct.
While the target fed funds rate is effectively zero, the central bank could try quantitative easing (QE), where it increases the money supply by means other than rates, such as buying government bonds.
"The Fed is not yet in panic mode, but the market simply does not know if we will get more QE or direct purchasing of Treasurys," O'Sullivan said.
With volumes low over the summer, bets against the dollarare at a yearly high and this could lead to a short squeeze, where prices rise rapidly as investors try to cover short positions on the greenback, O'Sullivan said.
"If the (European Central Bank) and (Bank of England) follow the Fed's lead, any move on QE could be dollar positive," he said. "Even if the Fed spooks the market the dollar could gain on a flight to safety."
President Barack "Obama has been very vocal on austerity measures in the (European Union) and UK, but there is a chance of short-term decoupling," O’Sullivan said.
Fed's Hand Will Be Forced
David Blanchflower, a former member of the Bank of England' monetary policy committeewho now teaches at Dartmouth College, said he believes the Fed will be forced to move either today or next month.
"The problem in the UK is that this new government's come in and doesn't seem to have much of a clue about eonomics."
"The US economy in particular is not steaming into action on the jobs front," Blanchflower said. "That's really affecting people's confidence. And it's not clear we actually are on the right track and I think that the Fed, if not this month … will probably do something in September."
"The worry is that growth is anaemic and we could be pushed back into double dip," Blanchflower said.
And the UK will not be able to avoid following the Fed's lead, he said.
"The problem in the UK is that this new government's come in and doesn't seem to have much of a clue about economics," Blanchflower said. "It's made a set of announcements about what it was going to do but didn't really understand where the economy was."
"On Friday the (Organization for Economic Cooperation and Development) talked about the UK economy being in double dip, moving into, if you like, a peak, a slowing," he said. "The problem is if it's slowing and you decide to cut fiscal policy like mad, you cut spending and raise taxes then really that puts huge strain on monetary policy."
"Interest rates are sitting at zero essentially, so what's plan B? The only plan you've got is more QE, and the pressure on the UK to do it will be huge." Blanchflower said.
The Higher-Rate Camp
Sir John Gieve, deputy governor and the person in charge of financial stability at the BoE when the financial crisis hit, said both the US and Europe will avoid another recession and that he thinks it will not be long before higher rates are being discussed.
"We wont actually see a double dip in the US or Europe," Gieve said. "By the end of this year, the beginning of next, well have seen another two quarters of not very interesting but still proper growth."
"At that point I expect the European authorities to start saying that 'if we've had four quarters of growth do we need emergency levels of interest rates?'" Gieve said.
"The BoE has an inflation target so the BoE would be within its rights if there is a case for raising rates," John Wraith, a fixed-income strategist at BofA Merrill Lynch Global Research, said. "The Fed’s remit is less clear."
“We do, though, have some concerns about Europe," Wraith said. "What goes around comes around and euro-zone growth is being driven by German exports. A higher euro and weaker demand from the US would be bad for German exports.