Friday, October 29, 2010

Fears of Quantitative Easing Affect Already Weakened Dollar

The US dollar is once again facing downward pressure, part of a much longer trend.

The dollar began a descent in 2002, and has ultimately declined by one-third since then, measured against a basket of six other currencies. From its high in summer 2001, the dollar had actually dropped 38% by the end of 2009.

Even worse, over the 25-year period since 1985, the dollar has lost more than half of its value. And if it wasn't the world's reserve currency, it would have declined even further.

What this means is that, in global terms, the purchasing power of U.S. consumers has declined dramatically.

A combination of ultralow interest rates, deficit spending by the government, and a large expansion in the money supply has had a very negative influence on the strength of the dollar.

So-called "quantitative easing" has an inflationary effect by increasing the money supply without a commensurate increase in the amount of goods and services in the economy. This is ultimately negative for the dollar.

It is widely anticipated that the Federal Reserve will announce the initiation of another round of quantitative easing at next week's policy meetings, on November 2 and 3.

Just the fear that the Fed will once again be printing as much as a trillion dollars – the very definition of inflation – has inflamed concerns about the value of the eroding dollar. The last round of easing sparked a worldwide flight to other currencies.

The IMF says that dollars currently account for about 62 percent of the total currency reserve at central banks -- the lowest on record. Clearly, those banks have lost faith in the dollar.

The declining dollar has a huge effect on investments that are re-paid in dollars. Investors and central banks are being paid back with a currency that has been continually losing value over time. That hurts confidence, and confidence in a currency is everything.

If it continues to decline, the dollar's status as the world's reserve currency would be put at risk. If the US ever lost this privilege, it would result in dramatically higher interest rates, as well as more-expensive oil and other imported goods.

A combination of savings, spending, interest rates, inflation, money supply, economic growth, government policies and trade balances can all affect the dollar's value.

The dollar index, which measures the dollar against a group of six other currencies, fell to 77.25 on Thursday. That's not so far off from its record low of 71.99, set in March of 2008.

Since September 20, the day before the last Fed meeting, the dollar index has dropped 5%, hitting its lowest level this year in the process.

The Fed knows that the dollar is facing heavy headwinds, so it will most likely take an incremental approach, starting with something in the $100 million range. That will give it leeway to conduct further rounds of easing as it sees fit in coming months.

Yet, it would hardly be surprising if the Fed ultimately prints $1 trillion, or more, in the next few months.

That money will be recycled into even more US Treasuries and, perhaps, mortgage securities, with the hopes of pushing historically low interest rates even lower.

However, any additional easing, above and beyond the $1.7 trillion already pumped into the banking system over the past two years, will be greeted inhospitably by bondholders and anyone that holds dollars.

After all, the yield on the 10-year Treasury was just 2.66% yesterday. Yes, it's well above the inflation rate, but it is historically paltry nonetheless.

Meanwhile, yields on 2-year notes stand at just 0.36%, barely above the record low set on October 12 (0.33%).

Only the fear of even lower returns elsewhere would compel any investor to lock up their money for years at a time at that those meager rates.

Right now, there is a lot of fear and uncertainty in the markets. While next week's Fed meeting may end at least some of the uncertainty, it will likely end up raising the fear level.

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