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Why Hold Dollars if the Fed is Going to Intentionally Deflate Their Value?

Currencies / US Dollar Jan 17, 2011 - 12:54 PM GMT

By: Ned_W_Schmidt


Best Financial Markets Analysis ArticleAs everyone seems to know, and as you have read endlessly in innumerable reports, the Federal Reserve has expanded its balance sheet by more than two trillion dollars. At present is in the process of adding another six hundred billion dollars of assets by monetizing U.S. government debt. At the same time, Obama Regime's deficit has spiraled out of control. Correctly measured, that deficit for the past year was $1.7 trillion.

What have been the consequences of these grand Keynesian schemes? U.S. unemployment is still above 9%, and likely to persist at that level for some time. U.S. housing market remains dysfunctional, and will likely continue to be for the remainder of the year. Most people in the U.S. over 50 will never recoup their investment in their homes.

Perhaps the only success of this program has been $Gold and the paper equity markets, both up more than 20%. We would not expect those two markets to move in similar fashion. Why might this happen? While no simple answer seems to jump out, one possibility is that investors were trying to get rid of dollars. Why hold dollars if Federal Reserve is going to intentionally deflate their value?

In above chart of the value of the dollar we can observe a high just before the Federal Reserve extended its program of dollar depreciation. Dollar's value, however, stopped declining about three months ago. With all we know of the Keynesian inspired mismanagement of U.S. monetary policy, why might that happen? Why is the dollar's value not continuing to fall? Why does it seem to be moving in a trading range, as indicated by rectangle?

Three answers seem possible to that question. One is that the U.S. economy is about to enter into a period of magical growth that will eliminate unemployment. A second might be that the world is about to discipline the U.S., as the IMF has done with many debtor nations, and U.S. interest rates will be materially higher a year from now. Third is something none of us imagine.

Around the world, U.S. monetary policy is starting to cause some serious pain. Brazil is suffering from the real's tremendous rally as hot money from hedge funds, financed by artificially low U.S. interest rates, flows into that nation. The real's value is starting to hurt. We note that this is the second time in not many years when the Brazilian real has gone on a roller coaster ride due to irresponsible U.S. monetary policy.

Swiss National Bank(14 January) reported that the central bank's loss for 2010 will be about 21 billion francs. Only good news in that report was Gold, which had a positive valuation gain of about 6 billion francs. Their exchange rate losses were on the order of 28 billion francs. Would imagine that the Swiss are not too happy with either the Federal Reserve or the European Union. Would also imagine that they might be having second thoughts on having sold their Gold.

The above are two examples, of the many possible, of market participants that might be growing weary of governments not acting in a financially responsible manner. This list of irresponsible financed governments is way too long, from Greece to the U.S. to Illinois and California. And all of that irresponsible financial behavior has been justified by the delusion of Keynesian economics.

In our January letter we outlined the changes going on with the Chinese Renminbi. That nation, in a very evolutionary manner, though bold in direction, is moving to make the Renminbi a global currency. Given the economic power of China, a reserve currency role for the Renminbi is inevitable, though it may not be immediate. They seem to have grown weary of platitudes out of Washington, rather than real action. January issue of Value View Gold Report goes into more detail on this.

Another emerging change deals with the Euro. Fire storms often eliminate the excessive build up of underbrush, allowing the flowers to again bloom boldly. That may be happening with the Euro, and the fertile soil for that flower could be the European Financial Stability Facility(EFSF)( 27 nations comprise the EU of which 17 officially use the Euro. Actual number of Euro users is larger due to unofficial acceptance of the Euro. 16 of those nations have come together to form the EFSF. It will offer €440 billion of bonds. This action is the first step, albeit a small one, toward a "national" Euro bond, and ultimately a bond market trading "national" Euro debt.

Per The Financial Times, 12 January 2010,

"Japan has pledged to buy more than 20 per cent of the eurozone's first ever bond issue, raising expectations that other international investors will support the pioneering fund-raising move, and help ease the region's debt crisis."

A major reason for the U.S. dollar's reserve currency status is the size of the tradeable U.S. debt. That debt is backed, both directly and indirectly, by the economies of the 50 states. With $14 trillion dollars of debt that trades on a regular and liquid basis, serving as a reserve asset has been facilitated. No serious competition as a reserve asset exists. The EFSF bonds are the first step toward competition. We would expect other nations, with already far too much invested in risky U.S. debt, to turn to these bonds as an alternative. Caveats of course exist, but let us not ignore the obvious by focusing on minutia.

To make a long story fit our allotted space, Gold has served as an intermediate step. In the future, the Euro will become a reserve currency. That too is an intermediate step as the world awaits the Chinese Renminbi to mature sufficiently and gain that elite status. As these developments play out, the longer term implications are negative for the U.S. dollar, and Gold denominated in Euros or Renminbi. They are positive for the Euro and Renminbi. $Gold should still perform better than the U.S. dollar. Currencies of nations such as Canada, Australia, etc. all move further down in the global pecking order of national monies.

How all this plays out is the big question. All we can do at this time is to pose the question, and work to answer it over time. What we do know is that giant change is occurring in global currency relationships. Do not remain mired in that which worked yesterday.

By Ned W Schmidt CFA, CEBS

GOLD THOUGHTS come from Ned W. Schmidt,CFA,CEBS as part of a joyous mission to save investors from the financial abyss of paper assets. He is publisher of The Value View Gold Report, monthly, and Trading Thoughts, about weekly. To receive these reports, go to

Copyright © 2010 Ned W. Schmidt - All Rights Reserved

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