Bear Mountain Bull

Commentary from Axel Merk:

Faced with the threat of deflation, the Federal Reserve (Fed) may be trying to drive the dollar lower to spur inflation. As policy makers don’t want home prices to deteriorate further, an alternative is to inflate the prices of all other goods and services: as a result, the relative prices of homes would be less expensive. Weakening the dollar is an effective policy tool to drive up inflation as the cost of import goes up. Just be careful: the Fed may be getting more than it is bargaining for. Fed Chairman Bernanke believes that a weaker dollar will only drive up inflation modestly; in our humble opinion, we believe he may be mistaken. Foreigners have a limit on how much margin pressure they can absorb before they have to pass on the higher cost of doing business. We saw this phenomenon in the spring time, when higher commodity prices forced Asian exporters to drive up prices; import prices into the U.S. were up over 20% year over year (and still up substantially after factoring out what was soaring oil prices at the time). No country has ever depreciated itself into prosperity and the U.S. is unlikely to be the first.

The Fed has been progressively more aggressive in attacking the dollar. Low interest rates are the traditional policy tool to make a currency less attractive. Short-term interest rates are now at historic lows; interest rates set by the market rather than the Fed are even lower.

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Importantly, foreign investors are also told their money is not welcome. Foreigners in recent years have been buying the bulk of U.S. Treasury and agency debt. But if these prices are driven artificially high (the yields artificially low), at the very least on the margin – foreign buyers may abstain. Further, Asian investors in particular need their money at home as a domestic stimulus within China is far more efficient than to try to prop up the U.S. economy with debt purchases. The Fed may be able to keep the yield on securities low, but it does so at the expense of the dollar.

The Fed is faced with far greater challenges than Japan. In Japan, there were few foreign creditors. Further, in Japan, all yields – both government and corporate – were low. In the U.S., while the cost of borrowing for the government is low, the private sector is faced with very high financing costs. Rather than the “quantitative easing” that we saw in Japan where the Bank of Japan targeted the reserve levels at banks, we will see a “qualitative easing” in the U.S., where the Fed is going to be closely involved in allocating credit to sectors of the economy it wants to stimulate. This sort of interference with market prices will have unintended consequences, costly side effects. In our view, these will play out in the currency markets. Watch that dollar carefully.