The dollar stands at a critical juncture as investors await policy decisions from three of the world’s main central banks this week.

The Federal Reserve delivers its verdict on monetary policy on Wednesday, while the European Central Bank and the Bank of England give their verdicts on Thursday.

The decisions come as the rallies in risky assets such as stocks, commodities and higher-yielding currencies look vulnerable. This has stoked haven demand for the dollar, pulling it back from multi-month lows.

Since hitting a 14-month low of $1.5061 against the euro at the start of last week, the dollar has rallied 2 per cent as global stocks have retreated.

Analysts say investors are feeling increasingly uneasy over the sustainability of the global economic recovery as ultra-loose monetary policy accommodation is gradually removed.

“The world is a bit like an alcoholic that’s become too reliant on central bank liquidity,” says Steve Barrow at Standard Bank.

“We might still be many, many months away from the first rate hikes from the likes of the Fed, ECB and the Bank of England, but it seems that the market wants to panic now, rather than wait.”

Some central banks have already moved to withdraw monetary accommodation. Commodity-rich Australia and Norway raised interest rates last month, while India moved to tighten monetary policy by increasing the capital requirements of commercial banks.

But it is the actions of the main central banks, particularly the Fed, that will determine wider trends in the currency market.

Analysts say this week’s Fed meeting is likely to prove key in determining whether the current downward correction in risky assets and the dollar rally extend further.

There has been growing speculation that at upcoming meetings the Fed will drop its commitment to maintain loose monetary policy for an “extended period”.

“If we do get a change in forward-looking language, markets would likely view this as a signal that the Fed is getting closer to tightening monetary policy,” says Ray Farris at Credit Suisse.

“The dollar would stand to benefit from a consequent move higher in yields to the extent it moved interest rate differentials back in the dollar’s favour and also served to exacerbate pressure on risky positions more generally.”

But analysts say the Fed faces a delicate balancing act. The equity market rally has partly been driven by US investors seeking higher returns on the cash stockpiles parked in low-yielding money market funds after the financial crisis. Thus, dollar weakness and global equity market strength have run hand in hand.

But analysts say concerns over long-term inflation risks in the bond market have risen. This spilled over into the currency markets last month, sending volatility, and thus the price of insuring against a rise in the dollar, sharply higher.

In turn, the rising cost of hedging currency risk increased the cost of holding short positions in the dollar, undermining the funding position for equity markets that had been supported by cheap dollar liquidity.

Hans Redeker, at BNP Paribas, says understanding this mechanism is important for trading the currency markets successfully.

“The source of rising currency volatility is in bond markets and the related assessment of long-term inflation risk,” he says.

Mr Redeker says that the Fed therefore is facing a dilemma when it decides on the wording of the statement after its policy meeting.

He says leaving the statement unchanged signals that the central bank will keep the floodgates of monetary accommodation open for an extended period, which might be initially cheered by equity markets.

“But in order to get the all-clear for further dollar weakness, the bond market has to remain constructive,” says Mr Redeker. “If the bond market loses confidence in the Fed’s stance of guaranteeing price stability, the equity market rally will soon hit the wall again, with a stronger dollar working as the catalyst.”

The ECB’s decision on Thursday is likely to have less impact on market sentiment, with the vast majority of forecasters expecting no change in policy outlook or interest rates.

But the Bank of England’s decision is likely to be more closely watched amid speculation that the central bank could extend its quantitative easing programme by as much as £50bn ($82bn) to £225bn after the surprising fall in third-quarter UK GDP.

Mr Barrow says the BoE’s decision on QE could be crucial, not just for UK markets but for global markets too.

“If the Bank goes against the consensus and pauses or, worse still, stops quantitative easing, the market’s fears about liquidity withdrawal will rise even more and there could be a bloodbath in stocks,” he says.