After a few
months out of the currency spotlight the Federal Reserve will once again be the
focus for traders when the Federal Reserve Open Market Committee (FOMC) meets
this coming Tuesday and Wednesday. This time it will not be
the Fed Funds target rate, the central bankâ€™s chief historical policy tool, that
will be the locus of interest but the several special programs that the Fed has
used to stem the financial crisis, in particular the quantitative easing attempt
to cap Treasury interest rates.
Various Fed disbursements have added more
than one trillion dollars in liquidity to the United States financial system.
With up to $3.25 trillion in Federal debt sold or slated to be sold in the
credit markets before the end of the US fiscal year in September oversupply and
inflation are serious potential concerns that could drive Treasury interest
rates considerably higher.
The 10-year Treasury note has risen more
than 1.6% in yield since March and the reason for this sharp increase has gotten
much speculative coverage in the press. But in fact the yields on the 10-year
note have simply returned to where they were before the financial collapse last
fall. Treasury yields have been trending downward for more than twenty years.
It was the dip to zero yields in the wake of the Lehman failure that was the
singular event not the recent return to trend. That is not to say that the huge
coming supply of Treasuries and the theoretical inflation potential of the
projected Federal deficits could not drive Treasury rates much higher. But the
Friday close of the 10-year Treasury at 3.78% is a likely starting point for an
inflation fueled run higher in yields, not an indication that it has already
The currency market reaction to the Federal Reserve quantitative
easing policy was as negative for the dollar as the policy itself was
ineffective. If the goal of the policy were to put a floor under Treasury
prices it failed. If its purpose was to indicate a serious Fed concern for
consumer interest rates and hope that the bond market would take the hint it was
also a failure. The quantitative easing purchase amount of $300 billion was
always far too small to prevent a fall in Treasury prices if market sentiment
Quantitative easing has been detrimental to the dollar
for three reasons. First and most important it monetizes US debt. With
trillions of dollars more of US debt yet to be sold this year alone any hint
that the US will print dollars to pay for its own debentures is anathema to
currency traders and to holders of US debt. The fact that the policy was a
failure, Treasury rates rose despite the Fed purchases, was unimportant. It was
the potential flood of new dollars that impressed the currency markets. Second,
if the US economy could not tolerate a return to more normal Treasury rates from
the abnormal levels of March when the 10-year note was in the low 2.00s% then
what possibility was there for an economic recovery anytime soon? And finally
if the Fed were willing to take the momentous step of buying Treasury issues to
keep interest rates from rising then any speculation that the Fed might begin
raising rates sooner than expected was misplaced.
When the Fed
announced its quantitative policy in March 18th the governors were in reality
utilizing their other traditional economic policy tool--Talk. Given the small
amount of the announced purchases and the six months time frame the Fed must
have hoped that the mere existence of this exceptional precedent would hold the
Treasury market much as intervention can sometimes deter the currency markets.
The governors must have known that $300 billion would never thwart a determined
Mr. Bernanke also chose to use this traditional central
bankerâ€™s tool to limit the effect of the quantitative easing policy. In
testimony before Congress on June 3rd he said that â€˜deficits cannot continue
foreverâ€™. It is of course a truism, but it is a truism with a point. The Fed
does not control the deficit and rarely makes comment on fiscal policy. But it
does control the Fed purchases of Treasuries. The goal of the easing policy was
to bolster the consumer economy by keeping mortgage and other consumer rates
from rising to levels where they inhibit consumption. Was this criticism of the
administrationâ€™s deficits an indication that the Fed now views the easing policy
as a failure? If that is the case then the link between the deficits and
quantitative easing is the dollar.
Nothing will be more damaging to the
Obama administrationâ€™s deficit funding plans than a collapsing dollar. The mere
hint of such a run on the dollar brought heavy and unusual criticism from the
Chinese and the Russians; their warnings are not empty. If the currency markets
drive down the dollar because traders fear monetization there will be
little that owners of US debt can do with
their current inventory, selling would only worsen the run. But China and Russia
do not have to buy more Treasuries; and the administration must sell Treasuries
or abandon its domestic agenda. A substantially lower dollar could also bring
crude oil prices to $100 a barrel and beyond. One of the contributing factors to
the plunge in consumer spending in the US and elsewhere was the rapid rise in
The Fed cannot do two things at once. It cannot keep US
consumer rates from rising with a renewed and augmented quantitative purchase
program and hope to maintain a stable
dollar. The currency markets have made their view of quantitative easing quite
clear. Even though US interest rates rose from March the dollar fell.
Monetization is a greater threat to the dollar than rates are a support.
The Fed governors must decide which is more important: domestic
interest rates or a stable dollar. The
FOMC approach to quantitative easing will provide the answer. This is an
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