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The Dollar: It's Payback Time!

It's payback time for Ben Bernanke, the chairman of the Federal Reserve (Fed). In some ways, this should neither surprise, nor scare anyone. Unfortunately, however, it might do both.

Bernanke Cartoon

In any open market, information is absorbed rather quickly into asset prices, including exchange rates. Indeed, exchange rates may be the best pricing source to assess the impact of the relentless involvement of policy makers' "print and spend" mentality in the markets. When trillions are spent, markets are likely to move. However, an unintended consequence has been that a broad range of assets are now moving more and more in tandem, giving investors fewer options to diversify. Investors should be mindful of this development, as markets do not always go up: where do you hide when the mood turns sour? In fact, why bother buying stocks, thereby taking on corporate risk, when ultimately the reason stocks are moving may have little to do with managerial skill. The U.S. dollar, one might argue, says it all. Be aware, though: there is no such thing anymore as a safe asset, and a diversified approach may be needed for something as mundane as cash. Investors these days may want to consider managing the U.S. dollar risk of their U.S. investments.

Generally speaking, payback time should be embraced rather than feared. Your compensation should reflect your good work. When, instead of gold, you receive devalued dollars as compensation, things might be different, though. When consumers are struggling to make ends meet because of soaring food and energy prices, when unrest is erupting around the world, then Bernanke might be haunted by the French philosopher Sartre's view that the weight of the world is resting on his shoulders.

Bernanke has chosen to shoulder his responsibility through increased transparency. In a world saturated with information, he is trying to explain his policies to the public. It's unlikely that those outside the world of financial markets will listen to the press conferences live, but headlines might sink in. Bernanke's inaugural press conference lead the Wall Street Journal to publish a cover page article entitled "Fed Takes Foot Off the Gas". As non-business publications cover the event, they may adopt a similar tone. The goal of the exercise is to manage public opinion, to ensure the public that inflation is "transitory." Unfortunately the term is increasingly ridiculed as for some, a period as long as a lifetime may be transitory. Bernanke needs to regain confidence of an ever more skeptical public before the term "anchored inflation expectations" suffers the same fate as "transitory." You see, the world of central banking is a mind game: as long as there is unconditional confidence that the Fed will do whatever it takes to keep inflation in check, the bond markets are likely to behave. Indeed, the Fed may even get away with printing trillions of dollars if there is confidence that the Fed could mop up all this liquidity in 15 minutes, as Bernanke has argued.

The cheapest Fed policy is one where a central banker utters a few words. More expensive are interest rate cuts; emergency rate cuts are even more expensive; printing trillions comes next. It is not surprising that Bernanke wants to regain the initiative and set the tone. However, the tone set during Bernanke's press conference was one of gold moving steadily higher and the U.S. dollar steadily lower. For the month of April, the U.S. dollar was down versus all currencies we track.

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It was little news that food and energy inflation has been creeping up; it was also little news that inflationary pressures are now creeping into the rest of the economy. However, what became rather clear throughout Bernanke's press conference was that the Fed still wants higher inflation and may do little to contain it, other than to tell the public to trust the Fed. And that's where the problem is: trust in the Fed has been eroding. It started when the Fed moved away from managing monetary policy (influencing interest rates and money supply) and veered into fiscal policy by targeting specific sectors of the economy (buying mortgage backed securities, for example). It's never a good idea to try to take power away from politicians; it may be true that the Fed Chairman is more powerful than the President, but it's not polite to rub it in the face of Congress. In Fed talk it's "the resources of the Federal Reserve"; in plain English, it's the printing press. In our opinion, Bernanke has consistently underestimated the political component of his policies. As scrutiny of his policies increases, Fed policy will become ever more expensive. What that means is that should the Fed one day want to tame inflationary pressures once again, tightening may need to be employed on a scale that will cause severe hardship. Bernanke addresses those concerns with press conferences.

Actions, however, would speak louder than words. The words may appease some, but it may not be enough. That's because the Fed is not taking the foot off the gas; instead, the Fed has engaged cruise control at 160mph because the banking system will remain awash in money, while proceeds from maturing securities the Fed holds will be re-invested. Speeding at 160mph may be legal on the German Autobahn, but is only recommended when there are no obstacles on the road.

At this stage in the economic cycle, any recovery should be more robust. However, we don't have a strong recovery because we did not allow consumers to fully de-leverage. As policy makers don't want to see foreclosures and bankruptcies, they have been throwing a lot of money at the problem. As housing is entering a 'double dip', Bernanke acknowledges that a "QE3" may do more harm than good, meaning inflationary expectations could rise even beyond Bernanke's comfort level suggesting that Congress should employ fiscal policy to get the economy moving. However, even in the absence of QE3, there is plenty of monetary stimulus as banks are sitting on massive excess reserves.

And we would not be surprised if banks have started to deploy those funds - not necessarily to lend to consumers, but to buy Treasuries - the very securities the Fed has been buying. That's because recent regulatory changes make it unattractive to borrow from Fannie and Freddie, now branches of the government, and park that money on the Fed's balance sheet as excess reserves, pocketing the interest rate differential (spread); in plain English, until recently, one could borrow from one political establishment to give credit to another. As that risk free trade is winding down, banks may be borrowing cheap short-term money to buy longer-term Treasuries. That trade may be perceived as rather low risk as long as the Fed ensures the market that "rates will remain low for a considerable period."

However, the thought of an ivory tower academic driving at 160mph may not engender confidence. Debasing the U.S. dollar may only be the start. As we have cautioned in the past, this may well be a desired consequence, given that our analysis has shown that Bernanke embraces the dollar as a monetary tool in both word and action. But debasing the dollar may also be highly inflationary; the CEO of WalMart recently cautioned that the cost of imports from Asia is rising. Bernanke doesn't think so, pointing to research at the Fed that, historically, a weaker dollar, did not lead to inflation. But historically, neither tech stocks, nor housing prices could fall, either.


To be updated as this discussion evolves, please make sure you sign up to our newsletter. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.


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