Monday, October 25, 2010

Quantitative Easing and the Declining Dollar

The US dollar is the world’s reserve currency, so most international trade is conducted in dollars. Since WII, the dollar has reigned supreme. Gold and oil are also bought and sold in dollars. Therefore, confidence in the US dollar is critical.

Fluctuations in the US dollar influence the price of gold and oil, and even US stocks. In other words, when the dollar falls, the price of gold and oil goes up. This is due to the diminished purchasing power of the dollar.

And as confidence in the dollar declines, interest in the safety of gold increases. The precious metal is historically viewed as a store of wealth.

The US government and Federal Reserve — like other governments and central banks — typically don't like gold's competition with the dollar.

Gold can't be printed at will, and it can't be loaned into existence. Gold doesn't generate interest, therefore it isn't a fundamental part of the banking system. And since it isn't a form of currency that can be exchanged for goods or services, it isn't a fundamental part of the US economy either.

However, the federal government is quietly championing the dollar's decline since it reduces the value of its debts. In essence, the US can pay back fixed costs (debts) more cheaply with devalued dollars.

Additionally, President Obama has pledged to double US exports by 2015. The only way that can happen is by devaluing the dollar relative to other currencies, making US goods cheaper overseas.

Yet, the US is not alone in this goal. All export-dependent nations (China, Germany, Japan, etc.) want to hold their currencies down in order to increase exports. Essentially, the entire developed world wants to devalue their currencies because this makes exports more affordable and competitive in world markets.

Call it a race to the bottom. As Treasury Secretary Tim Geithner has noted, no country — including the US — can devalue its way to progress and prosperity.

What's at risk is protectionism, tariffs and outright trade wars.

Meanwhile, the Federal Reserve has virtually assured that it will soon begin another round of "quantitative easing," or an intended money-creating stimulus for the sputtering US economy.

In essence, the Fed will be printing hundreds of billions more dollars out of thin air. In return, it will purchase even more long term government bonds.

This is on top of the $1.7 trillion the Fed already pumped into the banking system over the past two years, which should scare the hell out bond investors.

However, the banks already have plenty of money to lend. They just lack qualified or interested borrowers. Nearly one-third of US consumers, or some 70 million people, are considered sub-prime and cannot qualify for a home loan. They're considered to be too much of a credit risk for lenders.

As this point, it's reasonable to ask why lenders weren't this risk-averse during the past decade? But I digress.

Additionally, millions more Americans either have no jobs or no confidence in keeping their jobs. And they have no confidence in the overall economy either. These are not prospective borrowers.

Meanwhile, US corporations are sitting on more than $1 trillion in cash. Count them out as potential borrowers as well.

The Fed can make more money available at very low rates, but it can't force people to borrow what they don't want or need.

More quantitative easing will put even further downward pressure on the dollar, the sum total of which will be increasing without a commensurate increase in the amount of goods and services in the US economy. That's what ultimately leads to price inflation.

Most of that freshly printed money will eventually find its way into the stock market, inflating the market's value regardless of corporate earnings. That's exactly what happened when the Fed undertook its last round of money-printing.

The market seems to have already priced-in the pending rush of Fed money; the Dow recently broke the 11,000 mark once again. When you consider the historically low rates of return for Treasuries, it's easy to see where all that money is instead flowing.

Quantitative easing will also devalue the dollar, which will just encourage other nations to devalue their own currencies so they don't lose export shares to the US.

The process of money creation will lead us down a very dark road in so many ways.

Inflation and an even greater devaluation of the dollar are two obvious consequences. Yet, those may be the objectives of the Federal Reserve, which actually seeks inflation as part of its mission.

Additionally, there is an increased risk of trade wars, tariffs and protectionism — which won't be good for anyone.

The eyes of the world will be on the next Federal Open Market Committee meeting, which take place on November 2nd and 3rd. Other governments and central banks will be watching with particularly keen interest.

Many other economies have a lot riding on the Fed's decision. Some have their currencies pegged to the dollar. Many nations, through their central banks, own enormous amounts of US debt, which could be negatively affected by more money printing.

In simple terms, holders of US Treasuries could suffer significant losses if the dollar continues to weaken. Obviously, that won't go over well — especially if it's seen as having been intentionally orchestrated.

Owners of gold and other commodities traded in US dollars will also have a particular interest. Further declines for the dollar would mean further increases for dollar-denominated commodities.

In part, the Fed hopes to push down long term interest rates even further. Savers will continue to suffer the consequences of low interest rates — at least in the short term.

However, in the long term, the massive and continually mounting US debt will likely lead to much higher rates. That's especially true if the dollar continues its long descent. Nobody wants to buy a falling currency, or debt denominated in that currency.

Markets rely on confidence, and if the Fed does anything to rattle that confidence, there will be a series of uncomfortable, if not unintended, consequences.

1 comment:

  1. Anonymous5:16 PM

    Great article, Sean. Very thought provoking. -Jim Duggan