• The currency market view of quantitative easing
  • Monetization or a stable dollar
  • The normalization of Treasury rates
  • A foreign veto on quantitative easing?

After a few months out of the currency spotlight the Federal Reserve will once again be the focus for traders when the Federal Reserve Open Market Committee (FOMC) meets this coming Wednesday and Thursday. This time it will not be the Fed Funds target rate, the central bank's chief historical policy tool, that will be the locus of interest but the several special programs that the Fed has used to stem the financial crisis, in particular the quantitative easing attempt to cap Treasury interest rates.

Various Fed disbursements have added more than one trillion dollars in liquidity to the United States financial system. With up to $3.25 trillion in Federal debt sold or slated to be sold in the credit markets before the end of the US fiscal year in September oversupply and inflation are serious potential concerns that could drive Treasury interest rates considerably higher.

The 10-year Treasury note has risen more than 1.6% in yield since March and the reason for this sharp increase has gotten much speculative coverage in the press. But in fact the yields on the 10-year note have simply returned to where they were before the financial collapse last fall. Treasury yields have been trending downward for more than twenty years. It was the dip to zero yields in the wake of the Lehman failure that was the singular event not the recent return to trend. That is not to say that the huge coming supply of Treasuries and the theoretical inflation potential of the projected Federal deficits could not drive Treasury rates much higher. But the Friday close of the 10-year Treasury at 3.78% is a likely starting point for an inflation fueled run higher in yields, not an indication that it has already begun.

The currency market reaction to the Federal Reserve quantitative easing policy was as negative for the dollar as the policy itself was ineffective. If the goal of the policy were to put a floor under Treasury prices it failed. If its purpose was to indicate a serious Fed concern for consumer interest rates and hope that the bond market would take the hint it was also a failure. The quantitative easing purchase amount of $300 billion was always far too small to prevent a fall in Treasury prices if market sentiment were negative.

Quantitative easing has been detrimental to the dollar for three reasons. First and most important it monetizes US debt. With trillions of dollars more of US debt yet to be sold this year alone any hint that the US will print dollars to pay for its own debentures is anathema to currency traders and to holders of US debt. The fact that the policy was a failure, Treasury rates rose despite the Fed purchases, was unimportant. It was the potential flood of new dollars that impressed the currency markets. Second, if the US economy could not tolerate a return to more normal Treasury rates from the abnormal levels of March when the 10-year note was in the low 2.00s% then what possibility was there for an economic recovery anytime soon? And finally if the Fed were willing to take the momentous step of buying Treasury issues to keep interest rates from rising then any speculation that the Fed might begin raising rates sooner than expected was misplaced.

When the Fed announced its quantitative policy in March 18th the governors were in reality utilizing their other traditional economic policy tool--Talk. Given the small amount of the announced purchases and the six months time frame the Fed must have hoped that the mere existence of this exceptional precedent would hold the Treasury market much as intervention can sometimes deter the currency markets. The governors must have known that $300 billion would never thwart a determined bond market.

Mr. Bernanke also chose to use this traditional central banker's tool to limit the effect of the quantitative easing policy. In testimony before Congress on June 3rd he said that ‘deficits cannot continue forever'. It is of course a truism, but it is a truism with a point. The Fed does not control the deficit and rarely makes comment on fiscal policy. But it does control the Fed purchases of Treasuries. The goal of the easing policy was to bolster the consumer economy by keeping mortgage and other consumer rates from rising to levels where they inhibit consumption. Was this criticism of the administration's deficits an indication that the Fed now views the easing policy as a failure? If that is the case then the link between the deficits and quantitative easing is the dollar.

Nothing will be more damaging to the Obama administration's deficit funding plans than a collapsing dollar. The mere hint of such a run on the dollar brought heavy and unusual criticism from the Chinese and the Russians; their warnings are not empty. If the currency markets drive down the dollar because traders fear monetization there will be littlethat owners of US debt can do with their current inventory, selling would only worsen the run. But China and Russia do not have to buy more Treasuries; and the administration must sell Treasuries or abandon its domestic agenda. A substantially lower dollar could also bring crude oil prices to $100 a barrel and beyond. One of the contributing factors to the plunge in consumer spending in the US and elsewhere was the rapid rise in gasoline prices.

The Fed cannot do two things at once. It cannot keep US consumer rates from rising with a renewed and augmented quantitative purchase program and hope to maintain a stable dollar. The currency markets have made their view of quantitative easing quite clear. Even though US interest rates rose from March the dollar fell. Monetization is a greater threat to the dollar than rates are a support.

The Fed governors must decide which is more important: domestic interest rates or a stable dollar. The FOMC approach to quantitative easing will provide the answer. This is an important meeting.