Wednesday, March 11, 2015

Federal Reserve Has No Good Options in Rate/Currency War

There are many opposing forces at play in the global economy today. We are living in truly historic, and unprecedented, times.

Central banks around the world have been steadily cutting interest rates — some into negative territory, a stunning development — as they fight to stimulate their beleaguered economies.

This is seen as an antidote to weak consumer demand. Low interest rates are meant to discourage saving and instead encourage spending.

Low rates also typically devalue a nation's currency, which keeps exports competitive.

Government bond yields in the eurozone have plummeted to record lows since the European Central Bank started purchasing government debt and other bonds this week. It's all part of a €60-billion-a-month quantitative-easing program aimed to stimulate the eurozone’s sluggish economy.

But yields in some european countries were already negative before the QE program began, and the market didn't seem to fully price in the arrival of QE. That means yields could be driven even lower — in some cases further into the negative.

Falling yields elsewhere in the world have drawn many investors into US Treaurys, which have a better return. However, this demand is only pushing Treasury yields lower. Call it an unintended consequence.

The flight from the euro and other currencies has pushed the dollar to 12-year highs.

The ICE dollar index, which measures the greenback’s strength against a basket of six rivals currencies, rose 0.66% to 99.26 on Wednesday. The index was on track to hit the 100-mark for the first time since April 2003.

The dollar has already gained nearly 13% versus the euro this year, and the two currencies are now nearing parity. That will hurt US companies that sell to Europe, one of our largest export customers.

Europe is a half-trillion dollar market for US exporters. A stronger dollar makes US goods more expensive overseas.

Meanwhile, the Federal Reserve seems poised to raise interest rates this summer, which would only exacerbate the currency divergence.

Big American firms that generate a large portion of their sales overseas will likely to see the impact of the stronger dollar when they report their first quarter results. Many companies are already warning that the stronger greenback will hurt their sales and profits this year. Foreign revenues will wind up looking weaker when converted back into US dollars.

With foreign interest rates so historically low, investors will keep buying the dollar. Simply put, the dollar looks like a better, safer, store of value right now, compared to other currencies.

The other side of the coin is that a stronger dollar also makes imports cheaper, including oil and other commodities. While that sounds good for the US economy, there are other consequences.

The US is the world's No. 3 oil producer, so plunging prices are hurting a major domestic industry.

At roughly $50 per barrel, the price of oil is leading to layoffs in the energy sector, particularly in states like Texas and North Dakota, whose economies have boomed in recent years due to fracking. The real estate markets in these states are now imperiled.

So, what will the Federal Reserve do next?

Inflation is barely existant. In fact, deflation is a bigger concern at the moment.

Consumer prices fell 0.7%,in January, the third straight monthly decline, while inflation over the past 12 months turned negative (0.1%) for the first time since 2009.

While that was largely driven by the huge drop in oil prices, surely it has given pause to Fed policy makers. Interest rates are typically raised to thwart inflation. Clearly, that's not an issue at present.

Additionally, raising interest rates would only: 1. Strengthen the dollar; 2. Funnel more foreign money into the US; 3. Hurt US exports; 4. Drive crude prices even lower; and 5. Maintain, or even inflate, the stock market bubble with that flood of foreign money.

The Fed's zero interest rate policy (ZIRP) has fueled increased risk-taking by borrowers and yield-hungry investors. The result has been a massive mispricing of financial assets, such as housing and stocks.

Yet, even with near-zero interest rates, demand for credit remains weak. Consumers aren't spending as robustly as they were prior to the Great Recession, and consumer spending drives roughly 70% of our economy. Higher rates will ultimately hurt housing and autos, etc.

On the other hand, low rates are hurting savers and discouraging saving.

You can see why the decision to tighten (raise rates) has to be such a tough one for the Fed at present.

Deflation is the biggest nightmare of governments and central banks because it makes it harder for countries to pay off debts. The US is currently grappling with an $18 trillion national debt. That's why the Fed may feel compelled to act.

But there are so many wheels simultaneously in motion throughout the global economy. Any Fed action will have resulting reactions, not all of which will be intended or desired.

It's easy to argue that there are no good choices. Fed policy makers are damned if they do, and damned if they don't.

This is shaping up to be another stunning year for the global economy. Watching it all unfold will be equally fascinating and unpredictable.

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