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Tuesday June 16, 2009 - 19:46:26 GMT
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Treasury Rates and the Dollar
In a normal world these two charts would be complementary. As interest
rates on the 10-year Treasuries rise one could reasonably expect the
Dollar Index to follow. But ever since March18th when the Federal
Reserve announced its $300 billion quantitative easing policy, the
divergence has been pronounced.â€”the higher Treasury rates climb the
lower the Dollar Index sinks. Has the natural order of the currency
markets been upended?
10 Year Treasury Yield 1 Year Chart
Dollar Index 1 Year Chart
In normal economic times the currency market and the bond market
respond to the anticipation of higher US rates. The price of Treasuries
fall, the yield climbs and the dollar gains. It is the expectation of
returning economic growth and inflation that piques the anticipation
for a new upward rate cycle from the central bank. If this were a
standard recession, with three quarters of negative growth already
past, historically low rates, large amounts of additional liquidity,
and the first stirrings of recovery, market anticipation would focus on
the changeover to a restrictive rate policy.
But these are not normal times. Fed rate policy is constrained by the
recession and the residue of the financial crisis. The Fed cannot and
will not raise rates until the economy is clear of the threat of
deflation and the financial system has restored its ability to lend and
supply credit to the economy.
The Fed is in a bind. If it lets consumer interest rates rise it
undermines the economic recovery its policy has been trying to foster
since last year and risks choking off whatever economic stabilization
has been achieved. But if it increases its purchases of Treasury debt
to keep rates low then it provokes fears of future inflation; and, what
is perhaps more damaging, the suspicion that the US government is
willing to monetize its debt.
In the current economic environment, and especially in light of the
governmentâ€™s unprecedented funding needs, extensive Fed purchase of
government notes, quantitative easing, will cause as much harm as good.
â€˜Quantitative easingâ€™ is simply a different term for the monetization
of government debt. The Federal Reserve buys debt issued by the
Treasury and the Treasury uses the proceeds of the sales to pays its
bills, which means distributing the new dollars to the economy.
The inflationary result of quantitative easing is twofold. It
contributes directly to present inflation by increasing the money
supply and by devaluing the dollar, raising the cost of dollar priced
commodities like crude oil. Higher oil prices feed back into consumer
price inflation. Last summerâ€™s $4.00 a gallon gasoline was at least
partly caused by the historically weak dollar. The cost of gasoline
acts as a direct drag on consumer spending, reducing disposable income.
The pump price for a gallon has gained more than the dollar in the past
The second effect of quantitative easing is more insidious but
in the long run far more damaging to the US dollar. If higher rates for
US Treasuries indicate an oversupply of these dollar assets then they
pose a danger to the dollarâ€™s status as the worldâ€™s reserve currency.
One of the basic functions of a reserve currency is as a store of value
for liquid assets. If investors look into the future and see only an
ever increasing supply of dollar assets for sale, in numbers far beyond
the rate of economic growth in the US, issued by Washington to fund its
deficits, then the value of those assets will likely to fall..
The financial crisis was a singular event and it prompted an
unprecedented flight to quality in the Treasury market. The demand for
security was so great that Treasury yields fell far below historical
analogues. Two developments particular to the Treasury market and
abnormal in the sense of never having occurred before have kept the
currency markets from responding in a standard fashion to the rise in
First, the recent increase in the 10-year yield has taken place in the
contest of historically low Treasury rates. The 2.03% yield of last
December was an anomaly and the return to more normal yields should not
be taken to mean anything but that the most extreme portion of the
financial crisis is passed. Higher Treasury yields do not in this case
mean a change in Fed policy is near.
10 Year Treasury Yield 20 Year Chart
The second Treasury market development is also brand new and without
historical example: the budget plans of the Obama administration.
The Democratic administration isnâ€™t just issuing record debt this year.
For the next ten years, in the governmentâ€™s own projections, deficits
never drop below $500 billion in any year. The administration claims
that this scale of debt is necessary to help the US avoid the worst
effects of the recession. But the costs of the array of new programs
that are part of the budget projections dwarf anything that the US
government has ever enacted before. Every dollar of this new spending
will have to be borrowed.
For the Treasury market the vast supply of issuance threatens
to overwhelm demand. This quantity of government debt has never been
put for auction to the worldâ€™s investors. Their response is unknown.
Will the United States government be able to sell its debt and fund its
deficit? Yes. The question is at what cost. How much higher will
returns have to go to keep buyers purchasing US securities?
In pushing Treasury rates higher, the bond market is
responding to the enormous pending supply of government debt and to the
historic lows in Treasury yields that resulted from the financial
panic. 3.7% yields in the 10-year Treasury are not indicative of a Fed
on the verge of a restrictive interest rate policy. .
Because both developments were singular to the Treasury market and do
not yet represent a scenario dangerous for the US economy the currency
market response was muted. It remains to be seen if currency traders
view the projected massive increase in American debt as a positive or
negative for the dollar.
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