Many investors believe the Federal Reserve will remove the word "patient" from its policy statement on Wednesday, paving the way for an interest rate hike as early as June, but analysts warn that a dovish surprise would send the U.S. dollar sprawling.
"U.S. dollar long positions are at record levels and the currency markets have already priced in the removal [of word "patient" from its statement] and a rate hike in June," said National Australia Bank's co-head of FX Strategy Ray Attrill. "[If the Fed don't remove "patient"], the U.S. dollar could fall by one to two percent against major currencies such as the euro and Australian dollar."
While dollar declines would be swift, they shouldn't be unexpected given the greenback's recent run-up. The U.S. dollar index has risen around 25 percent since July 2014 as investors priced in an eventual Fed rate hike and amid the search for yield against a back drop of central bank easing around the world.
"Given the strength of the consensus and the record long positioning, a dovish surprise postponing the start of the tightening would necessarily trigger a squeeze," said Societe Generale Forex & Derivatives strategist Olivier Korber in a note published on Tuesday.
"Investors should hedge the tail risk that the Fed maintains the 'patience' wording, or worse, talks down the dollar," he said.
The majority of investors reckon the Fed will drop the word "patient" from its statement later today.
Some 86 percent of respondents surveyed by Barclays in a client poll expect the Fed to remove the term, according to a note published on Wednesday.
Where opinions diverge, however, is when interest rates will be hiked.