What the Fed did this week
is no doubt consistent with a lower dollar. But is it the beginning of
the end for the USD as the worldâ€™s reserve currency? Or as one bank
currency strategist said Rome is
burning only this time it is the city on the Potomac.
To set the record straight,
I am not including gold, yuan, yen or real as alternative reserve
currencies. Nope, this is a race between the almighty buck and the euroschadenfreude.
I would say all else being
equal the dollar might be ready for its final act â€“ Wylie Coyote off the edge
of a mountain road and nothing but granite boulders to land on 1,000 feet
The problem is not all else
is equal, not even close. The Fed is trying to ring-fence deflation.
The ECB does not see any reasonable chance of deflation ahead, even when
forecasting a significant risk of declining CPI y/y for several quarters.
The Fed is engaging in a
rapid expansion of its balance sheet buying agency and government debt to near
$2trln (and likely to get even bigger) and going BOJ with quantitative easing
(Bernanke canâ€™t tell Congress again this is not Japan). The Fed is
very clear about why it has rates at zero and why it is buying assets by adding
zeroes to its balance sheet (checkbook)â€¦the banking system is broken and is not
functioning effectively as a transmission mechanism for monetary policy.
The ECB is ruling out
expanding its balance sheet by buying assets from the market directly as it
asserts the banking system is not broken and the transmission mechanism is
working. The ECB cuts rates and banks pass this on to customers and the
demand for money goes up. So cutting rates works â€“ we heard this from
Weber today. For the benefit of the doubters, there is some case to be
made that ECB fears going to zero bound and QE because it marks the move from
monetary to fiscal policy and there is no central fiscal policy in the EZâ€¦only
way QE could be carried out is by farming out unconventional monetary policy to
the national central banks (reverse problem the Fed has where Board is
empowered and FOMC Presidents are window dressing in unconventional monetary
Regardless why the ECB is
not embracing ZIRP and QE as a response to ring fence deflation (risk in its own
inflation forecasts), the important point in examining the prospects for the
euro emerging as the worldâ€™s preeminent reserve currency is that it is not
responding appropriately to the prevailing economic risk.
I donâ€™t want to completely
give the thumbs down to the ECB on its policy response to the crisis. It
gets an A for providing liquidity to the European banking system and accepting
all sorts of financial waste as collateral for funds whether in EUR or
USD. But this has never been a banking liquidity crisis. It has
always been a banking solvency crisis (capital market failure â€“ say that over
and over again and remember it when idiots call for letting capital markets
sort out a 100-year massive capital market failure) and liquidity shortages
reflect insolvency risks.
Bank America/Merrillâ€™s David
Rosenberg said in a note this week that the Fed announced it is buying bonds
not stocks. He noted that in March 2001 when Japanâ€™s BOJ embarked on
quantitative easing after several years of massive fiscal spending packages
were not working (banking system was broken, but there was no global capital
market failure and all else was not equal) the Nikkei rallied about 20% into
May and by July had reversed all of the gains to around 12,000 (got under 7,000
on recent downturnâ€¦this month). The yen weakened apart from a
bounce on 9-11 through early 2002 and then began to rally to new high versus
the USD culminating in an orgy of unprecedented currency intervention (yen
selling) ending in March of 2004. Japanâ€™s official rate was effectively zero and JGB yields
fell to record lowsâ€¦admittedly with negative inflation producing positive real
Yes I still hate
stocks. Yes I think financials will lead the way down again. Yes I
think the government will continue to put new capital into banks and avoid the
much feared (and underrated) nationalization (this crisis has funny ways of
bringing neo-Keynesians together with neo-classicists). And yes I think
the US is facing a lost half decade at least.
Europe is a basket case short of celestial intervention and
God sends a messenger down to recreate the pre-2007 financial world in a
restore system reboot. The US is not going to provide the updraft for JC Trichet
to be saved from his own religious dogma â€“ doctrine of one-sided price
stability. China wonâ€™t do it either. Russia could at $100 oil and it might be with tanks.
Gold, as much as I think it
is its own fiat fantasy (itâ€™s just metal, and not good for fashioning tools for
hunting and gathering), is the alternative reserve currency in the race to the
bottom of the USD and EUR and represents the hedge of last resort to deflation
and hyperinflation and at this period of the cycle that is not such a bad bet
(I fully think deflation is unavoidable and hyperinflation will not present a
serious risk for years â€“ after Wednesday the Fed clearly thinks so too).
Euro/dollar should put in a
top in the next few months and I have no clue where that will be â€“ maybe
1.45-1.50. But if the yen and QE is any guide and Europeâ€™s inherently vulnerable organization (monetary union without political
union) prevents an appropriate policy response in Europe, I think euro/dollar has new lows on it by year end.
Lastly, Japanâ€™s lesson holdsâ€¦when banks, firms and households
discover they have too much debt and deleverage, it is nearly impossible to
prevent. For all the credit Bernanke is due for taking bold step after
bold step in a world of still narrow minded thinking in the halls of government
and in the public, there is no evidence that an economy in deleverage mode will
respond to unconventional monetary policy. Maybe the lesson of the Great
Recession will be just thatâ€¦policy can only preserve social order, help the
most vulnerable and punish the most successful. Capitalism is mortally
not fatally wounded and it will take years to recover.
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