Tuesday, June 13, 2006

US Markets To Be Sacrificed

I think we should just consider the possibility that the Fed is willing to sacrifice US stock and real estate markets to keep the dollar afloat. The Fed could easily do this with a half point rate hike next with no indication that hikes are finished. Such a policy would have the support of our creditors. The resulting fire-sale asset prices would look very attractive to cash rich foreign buyers who are wondering what the heck they can do with all the dollars they have accumulated. In the resulting recession commodity prices might soften, and international trade would be able to continue, although at depressed levels.

I know I've been ragging on the dollar for a while, predicting its ultimate collapse to near worthlessness, but lately an alternate scenario has been brooding in my mind. Suppose the dollar doesn't collapse? Maybe the Fed can save the dollar. I think this is possible, but at enormous cost.

Joe Duarte describes the increasingly worried tone of the Fed, as expressed by Fed governor Janet Yellen:
"Ms. Yellen, and the Fed are slowly coming to grips with the gravity of the situation. Her remarks show that Ms. Yellen may just be starting to come to grips with the fact that despite the potential for an economic slow down, perhaps of some significance, the Fed may have to continue to raise interest rates indefinitely, just to keep the dollar from collapsing."

Unfortunately, Wall Street is now counting on an end to rate hikes. Money managers have been saying for the last six months that the Fed has to be near the end of its rate raising cycle. They were saying "one and done" in December, or, in the worst case, then they would endure "two and through". Quarter point rate hikes that is. Since then we've had two rate hikes and they are not through. The horrible possibility of more rate hikes, or even the truly terrible, unspeakable thought of accelerated hikes (half a point instead of a quarter), has not been considered. If you are working on Wall Street, managing over a billion dollars and have a staff of traders, then you probably see the American financial markets as the center of the world, the key to prosperity and stability, the one thing that must be preserved at all cost. But the world is changing.

It has been said, by Jim Puplava and company, that the Fed "walks a fine line". They risk a dollar crisis and runaway inflation if they lower rates, and a real estate and stock market crash if they raise interest rates. Now it looks like they will have to choose one or the other. There is no such line that will avoid both these catastrophes, rather it is choose which one is the lesser of two evils. And hope that energy shortages or political crises don't bring us both. If the Fed keeps doing what it is doing, that is raise rates by one quarter point at every meeting, we will almost certainly get both a dollar crisis and market crashes. They can't simply stay the course because:

a) Central bankers around the world are getting very anxious about the dollar. Soon the Fed will not be able to withstand the combined attacks from currency speculators, Vladimir Putin, and Hugo Chavez.

b) The stock and real estate markets are clearly showing the strain from rising interest rates and energy prices. A crash is only a matter of time anyway. Markets around the world have all fallen heavily lately, but the American markets have only fallen in the single digits so far.

In the end the Fed will have to try defend the dollar to support the all important treasury bond market. This is what keeps the government solvent. And if things play out this way, I wonder how how much independance our Federal Reserve will really have anyway. I wonder if China's central bank Governor Zhou Xiaochuan, and Russian central bank chairman Sergei Ignatiev are now discrete and unofficial members of the Federal Reserve, and if they will be the ones who really set monetary policy.


Anonymous said...

Great analysis.

I agree with this analysis for the short term. It makes a lot of sense. The Fed is more powerfull than Wall Street and the Government needs the Feds dollar to continue spending given that the budget deficit is irretrievably out of control. The Fed and Government need the dollar more than they need wall street and certainly more than they need housing. I can also see that if the Government allows a deflationary collapse to delay a dollar collapse then foreigners may be attrected to bath in the firesale for a while.

In the longterm though the firesale will repatriate dollars back into the US adding back some or even all of the liquidity lost in the deflationary crash. Also firesales have the habit of being very short lived. The main factor however is that the US budget deficit will have been unaffected but now the debt servicing will be worse due to the higher rates. In the end the Government deficit will continue to balloon out of control simply from trying to service itself. The deflation wont have helped our pathetic export status so no new revenue to service debt there. The deflation will also destroy the public debt servicing ability so although the foreigners get a short term firesale ultimately they lose all servicing capability on their mortgage backed securities and T-bills other than by renewed dollar inflation.

This would be the point where all roads would lead to hyperinflation.


Peterbart said...

Interesting perspective, but I just don't see why the Fed would intentionally want to cause chaos. Given the instability in the markets, moving up a quarter of a point AND indicating that further rate hikes might be in order would seem to be a more orderly way of managing the situation. The markets would still react, but without the gnashing of teeth that would follow a half point hike.

Of course, the comments on the dollar being in big trouble are right on the money, so to speak, and this scenario represents a clever way to fix that problem, but it would cause so much pain to Americans (think homeowners; think pension funds) that it would just no be sustainable.

Anonymous said...

Hey, haven't you heard? Inflation concerns have eased according to Ben Bernanke who said that record energy and commodity prices could account for some of the recent up-tick in core prices, but that inflation expectations have remained within historical ranges. The market soaked up this good news and proceeded to rally 200 points as a result. Seems like people are entitled to believe whatever they want these days - irrespective of the facts. Just ask Helicopter Ben!