Just Speculating Here, but...

By: Ed Bugos | Wed, Jun 21, 2006
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Could the recently hawkish Fed rhetoric and changes in the reins of dollar policy be aimed at obscuring the true reason for the March/April (technical) break down in Treasury prices, which we argued last fall was going to be the most significant consequence of the expected drop off in Asian official sector demand for US dollars?

It would be the logical policy response.

After all, a drop in official sector demand should theoretically present an added inflation problem for the Federal Reserve if its growing stream of money (or fiduciary media as Mises regarded the issue of uncovered bank notes) is harder to 'place'. The administration's trade and foreign policies, to the extent they have been unpopular, have undoubtedly provided general impetus in this direction (although this is a factor that could be changed I don't believe it is likely to, at least given the current broader trade philosophy of the administration). But its criticism of China's foreign exchange and monetary policies in particular probably played a part in the Chinese government's own decision to diversify away from dollars, accentuating as well as confirming a more global trend in changing central bank reserve compositions - lessening the dependence on dollar "hegemony" as it were - growing for several years now. For, even up until about 2004 the enormous appetite of the Asian central banks for dollars went a long way in explaining Greenspan's yield curve conundrum. At least we thought it did. They bought so many dollars that the prior Fed chief pleaded that they stop.

But, despite the criticism levied against its handling of foreign exchange rates as well as its general attitude towards American policies in particular, China was nevertheless willing to continue to finance the twin US deficits. Why?

Mainly, the answer is because it worked for a while, at least until they realized the costs of sustaining the scheme.

The most important benefit was that it enabled them to maintain a relative trade advantage by "pegging" their currency to the value of the US dollar. In other words, in order to prevent the Chinese currency from climbing like its other trade competitors (Japan, Europe, etc.), i.e. to maintain the peg, and especially in an environment where the dollar was falling in value generally, the bank would have to buy dollars and dollar denominated securities like mad, which it did, at record rates. But the scheme eventually un-nerved China's competitors, yielding political pressure to float the exchange rate.

China has shown reluctant compromise by making gradual adjustments to the peg with the presumed (hinted?) intent of eventually letting it float - once it is comfortable with adequate safeguards against sudden inflows / outflows of capital, or so it says - and by gradually removing the monetary accommodation that helped maintain this peg. Adding to this problem of a significant decline in official sector demand for dollars, which is itself a limit on how much the Fed can inflate, was China's publicized intent to accumulate strategic commodity reserves for the future needs of its country.

So talking tough on monetary policy would be one way to offset the effects of any expected decline in foreign exchange demand, and to potentially generate Treasury demand. If the main benefactor of the previous Asian policy was the US Treasury market then the recent break down in bond prices could not have come as a big surprise in light of subsequent changes in its foreign exchange, monetary and trade policies. Psychologically, however, it could have serious further implications for foreign dollar demand if the break down is perceived as the result of a diminishing appetite for dollars rather than a tough Fed. Although our hypothesis is speculative (i.e. not likely to get corroboration even if it were true), if it is even part true, then the events we've witnessed (at the Fed and Treasury) appear to make more sense.

It's called damage control.



Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of GoldenBar.com, one of the original contributing editors to SafeHaven.com and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

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