A few days ago, Mish took on some of the views of the US bond market – and by extension ways the currency market as well. Part of the discussion relates to some of the stuff I’ve written here in the past, most recently in Interest Rates Due for a Breather Before the Taper, but goes a bit more into the perspective of foreign central banks in all of this. In doing so, Mish takes on the idea that if/when the Fed stops buying Treasury paper there won’t be any buyers.
This gets into the functioning of global trade. If the US is operating at a deficit of trade, which is the case, then it means there is a surplus of USD in the global system being held by those countries running a trade surplus. Those USD have to go somewhere, and invariably that’s into US Treasuries. As Mish notes, the argument gets made that those surplus countries like China can/should invest the dollars into hard commodities, but that has negative implications in terms of the strength of their currency (buying Treasuries means not selling their USD, thus weakening the dollar) and in stockpiling stuff they don’t necessarily need at potentially inflated prices.
I will add another argument to the case.
The Fed does Q.E. by purchasing Treasuries in the open market. Who do they buy from? Holders of Treasuries, meaning those who have previously bought them either in the market or from the Treasury at auction. In other words, there was already a group of buyers of Treasuries in the market before the Fed came in to buy them. The Fed can be looked at as just another big portfolio manager in the market. Will there be an effect on rates when they slow/slop their purchases? Of course. Just as there would be if PIMCO and its massive capital base got out of the market.
The interesting aspect in the situation looking forward is what will happen in terms of Treasury issuance. If the economy continues to positively progress it will mean improved tax revenues, and thus a lower federal deficit. If Congress is able to also meaningfully reduce the expense side of things (the bigger ask of the two), that will accelerate the deficit reduction process and further reduce the need for the Treasury to issue paper. That reduced supply will have an offsetting impact on the Fed cutting back on its purchases, which no doubt is part of the thinking of Bernanke (and his successor) & Co.
Bringing it back to the currency question, as Mish notes in his piece, one of the common claims by the loudest voices in the interest rate prognostication debate is that reduced Fed buying will negatively impact the dollar. This is said to be the result of no one wanting to hold depreciating bonds and because all the money in the economy will produce inflation-driven greenback devaluation.
The first part of that equation assumes the buyers/holders of Treasuries care about intermediate fluctuations in valuation. This is also something voiced in terms of the impact rising rates will have on the Fed’s balance sheet (which I discussed before in Prospects for More Upside in Interest Rates). I don’t abide by that argument and neither does Mish.
The second part of the equation, as I’ve noted before in different contexts, fails to take into account the other side of the exchange rate. The USD is valued in terms of other currencies. If that currency is equally at risk and/or exposed to the same factors said to put the dollar at risk of devaluation, then the greenback will not lose ground. In fact, the current situation sees many of the other major economies fairing worse than the US. This is far from a recipe for the type of rapid depreciation in the dollar some folks expect.