Dollar At Risk
Today, a nightmare scenario for the Fed is unfolding. Stocks are down sharply; bonds are down sharply; the dollar is down sharply, while gold and the euro are up. We are all aware how dependent the U.S. is on foreigners financing U.S. deficits. However, it’s not only the foreigners buying U.S. assets one has to be concerned about: if the trust of Americans erodes in the U.S. dollar, that flight could have rather severe implications.
One of the new revenue streams for institutional forex desks is to sell services to U.S. institutions to hedge their domestic currency risk. This type of service applied to a Western country was unheard of until not too long ago. American institutions hedging their U.S. dollar, i.e. domestic currency risk, is something to be monitored carefully.
Today’s move comes on the heels of S&P’s announcement to put U.K. sovereign debt on credit watch with negative outlook. If we want to see what may happen in the U.S., keep an eye on the U.K; the U.K. faces many similar challanges as the U.S., but doesn’t have the breadth to deal with them. In particular, the U.K. is learning that there may simply not be enough appetite to finance all the deficit spending the government is proposing. The task will be more complicated if the recovery is not soon and swift; we would like to caution that most of the "green shoots" we have seen are positive statements made by policy makers, but economic data have remained solidly negative.
The U.S. will have no problem financing its deficit, the question, however, is the cost. Trouble is that the one thing the Fed may fear the most right now is good news. If we get a series of good economic data, inflationary expectations may soar and bond prices may plunge further; that would push up the cost of borrowing, not just for the government, but for businesses and consumers as well. In such a scenario, any nascent recovery may be thrown into a tailspin.
Today’s market action has to be taken with a grain of salt as various countries around the world are closed for a holiday. Friday may be a perfect day for central banks to intervene as bond markets in the U.S. are open only half a day and European traders may take a long weekend. For now, the main concern of central bankers may be whether we are seeing warning shots or the start of a new trend. In our view, central bankers would be well served to return to sound monetary policy, away from trying to boost economies by printing money to finance government spending.
Axel
Axel Merk
Author of Sustainable Wealth
President and Chief Investment Officer, Merk Investments
