What's next for the U.S. Dollar? QE3?
The dismal U.S. jobs report for May, released last Friday, caused the price of gold to soar as the market appears to be pricing in an ever-greater chance of "QE3" - another round of quantitative easing by the Federal Reserve (Fed). But given that 10-year government debt is already down at 1.5%, the Fed may dive deeper into its toolbox in an effort to jumpstart the economy. Investors may want to consider taking advantage of the recent U.S. dollar rally to diversify out of the greenback ahead of QE3.
To a modern central banker, it may be very simple: if the economy does not steam ahead, sprinkle some money on the problem. The Fed has done its sprinkling; indeed, the Fed has employed what one may consider a fire hose. But after QE1 and QE2, we continue to have lackluster economic growth, unable to substantially boost employment. Never mind that the real problem the global monetary system is facing is that the free market has been taken out of the pricing of risk:
- When the Fed buys government securities, such securities are - by definition - intentionally overpriced. Historically, when a central bank buys government bonds, the currency tends to weaken, as investors look abroad for less manipulated returns.
- Policy makers increasingly manage asset prices, be that by pushing up equity prices through quantitative easing; artificially lowering the cost of borrowing of peripheral Eurozone countries; or by keeping ailing banks afloat.
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Investors increasingly chase the next perceived move of policy makers, thus fostering capital misallocation. Policy makers in Spain may not like paying above 6% for their longer-term debt, but lowering such rates ought to be the result of prudent policies, not because of a game of chicken between the Spanish prime minister and other European policy makers (if we only knew who the other chickens were - they are all hiding!). Similarly, U.S. growth is lagging because - let's just name a few of the root causes - of ongoing global de-leveraging; the de-leveraging of U.S. households; uncertainty over U.S. regulatory policy; uncertainty over U.S. fiscal policy.
But let's keep it simple, as it doesn't matter what we think. What matters is what our policy makers do. Bernanke has indicated that the Fed is willing to provide more support to the economy. The latest unemployment report might provide that impetus, especially given Bernanke's view that "The central bank should act more preemptively and more aggressively than usual." This quote comes straight from what may be considered Bernanke's playbook: his 2002 "helicopter speech" on how deflation can be beaten. Last fall, we browsed through the playbook to pose the question: Operation Twist a Primer for QE3? To recall, Bernanke argues:
- Deflation is in almost all cases a side effect of a collapse of aggregate demand....The best way to get out of trouble is not to get into it in the first place...The Fed should try to preserve a buffer zone: ...central banks ... set ... inflation targets ... between 1 and 3 percent, ... reducing the risk that a large ... drop in aggregate demand will drive the economy far ... into deflationary territory
When faced with deflation:
- The central bank should act more preemptively and more aggressively than usual...
- Deflation is always reversible under a fiat money system...the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost... a determined government can always generate higher spending and hence positive inflation.
QE1 has come:
- The Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.
Operation Twist and a commitment to keeping interest rates low for an extended period is also taken from the playbook:
- One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out the Treasury term structure - that is, rates on government bonds of longer maturities.
- One approach...would be for the Fed to commit to holding the overnight rate at zero for some specified period.
- A more direct method, which I [Bernanke] personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities... at prices consistent with the targeted yields... if operating in relatively short-dated Treasury debt [next two years] proved inefficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.
- Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities [MBS] issued by Ginnie Mae, the Government National Mortgage Association).
We had the MBS purchase program as QE1. We don't think a targeting of longer-term interest rates is in the cards, as rates are already quite low. To see what may be announced by the Fed in the near future, keep reading (emphasis added):
- Alternatively, the Fed could find other ways of injecting money into the system - for example, by making low-interest rate loans to banks or cooperating with the fiscal authorities
- If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities... the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.
- The Fed could offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, amongst others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.
What does that mean? Look at Europe's Long Term Refinancing Operations (LTROs). In Europe, the European Central Bank (ECB) has been providing unlimited liquidity to the banking system, allowing banks to get liquidity in return for a broad range of collateral. While U.S. banks are not in as dire a situation as European banks, Bernanke may be motivated to provide LTROs Fed style because it would allow banks, such as Bank of America, to turn their illiquid mortgage backed securities onto the Fed in return for liquidity. Key differences to QE1 and QE2 are:
- An LTRO is demand driven. Rather than the Fed buying a colossal amount of securities, unsure of what to do with a bloated balance sheet, the LTRO gets the money where it is in demand. A bank that wants increased liquidity - presumably to invest the money in riskier assets - will be willing to participate in the LTRO.
- LTROs are extremely profitable to banks rather than the Fed. Currently, the Fed earns over $80 billion a year: the more money a central bank prints, the more interest paying securities are purchased, thus the more "profitable" the central bank is (never mind the potentially eroded purchasing power as a result of having printed the money). The ECB, in contrast, only charges 1% in return for cash provided on collateral. Given the near zero interest rates in the U.S., expect the Fed to charge only a nominal amount to turn securities held by banks into cash.
What may hold Bernanke back is that he can't be sure of the impact a U.S. style LTRO might have:
- One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies.
Indeed, we have been critics of the ECB's LTRO because over one trillion euros in liquidity will need to be drained within a matter of weeks should the LTRO be closed out. We don't think this is feasible. However, the reason why these "nonstandard measures" have not caused major inflation is because policies in the U.S. and the Eurozone have not worked - the money doesn't "stick." With the U.S. recovery further along than the Eurozone recovery, the risk for Bernanke - and with that to the purchasing power of the U.S. dollar - is that banks will actually use the LTRO to get the economy going. If so, Bernanke claims to be able to raise rates in 15 minutes. We will see about that, especially in the context of his conviction that one of the biggest mistakes during the Great Depression was to raise rates too early. In our assessment, Bernanke must err on the side of inflation if he wants to stay true to his convictions. It's in that context that he has been willing to commit to keeping interest rates low until the end of 2014; incidentally, by that time, odds are high that much of the foreclosure pipeline will have been worked through thus allowing the Fed to return to more traditional monetary policy. That's the theory. In practice, little has worked out since the onset of the financial crisis as has been envisioned by policy makers; then again, the Fed is rarely accused of being too far sighted...
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In summary, we believe the next major initiative by the Fed will be the announcement of a U.S. style LTRO. Just in case that doesn't jumpstart the U.S. economy either, we will have to revert back to Bernanke's playbook to glimpse what else may be in store:
- The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchases by the Fed is several times the stock of U.S. government debt.
This policy suggestion demonstrates Bernanke's lack of appreciation for the political consequences of his actions. In his speech, he tries to address that:
- I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. Although... it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.
Our read is that Bernanke won't consider the outright purchases of peripheral Eurozone debt until after the U.S. elections. Even then, such a step may go beyond the bizarre. Then again, what hasn't been bizarre in U.S. monetary policy in recent years?
Back to the LTRO, such a policy would boost the Fed's balance sheet yet again. New money would be "printed" to provide the liquidity offered to the banking system. We live in an environment where central banks hope for the best, but plan for the worst. A U.S. LTRO would squarely fit that scheme. In that environment, the U.S. dollar may weaken and currencies sensitive to monetary stimulus may shine yet again. Having said that, we have long argued that there may not be any safe asset anymore and investors may want to take a diversified approach to something as mundane as cash.
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