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I still feel that the yields on long term Treasury issues and the value of the United States dollar are tied together. I have believed for some time now that long term interest rates will trend upwards over the next 12 months and that the value of the dollar will decline during the same time period. The strong rise in the 10-year Treasury and strong drop in the value of the dollar on August 3 just reinforce this belief.

In looking back at the 2002-2004 period, there are too many similarities to feel comfortable. The Federal government is presenting us with large and growing deficits. Monetary policy is ridiculously easy. And, the dollar is under pressure.

What about long term Treasury yields? Well, in that earlier period the United States had the Chinese to pick up large amounts of the exploding Treasury debt so that long term interest rates did not have to rise significantly and the Federal Reserve did not have to monetize the debt.

The reason for the Federal Reserve behavior at that time? Chairman Greenspan was concerned that we might experience a period of deflation!

There are two theories why long term interest rates have not risen further than they have this year. First, there is still a concern among major investors about investment risk and as long as this concern lingers, funds from these investors will remain in long term Treasuries.

Now, there is a second reason given for long term interest rates remaining low and that is the enormous amount of liquidity in the commercial banking system. In recent weeks, commercial banks have started to expand their holdings of U. S. Government securities and this has put funds into the Treasury market with some of it spilling over into the longer end.

Why are commercial banks expanding their holdings of U. S. government securities? Because the Federal Reserve has given out signals that it may keep short term interest rates low for an extended period of time: even into 2011. If this is to occur, then the reserves that the Fed has put into the banking system will have to stay for a while. That is, there will be no quick exit on the part of the Fed. Since the banks don’t want to lend to businesses or consumers they might as well get a higher yield than they do on reserves at the Fed by investing in market issues.

The reason for the Federal Reserve behavior at this time? Chairman Bernanke is concerned that we might experience a period of deflation!

As a consequence of the specific conditions of the present time, long term Treasury interest rates may not rise appreciably in the near term. However, I still believe that they will show a significant rise in the next 12 months.

I feel more certain about the decline in the value of the United States dollar. Participants in international markets are very reluctant to stick with the currency of a country that runs huge deficits with the strong likelihood that these large deficits will not go away for a long time.

Can you imagine a $2.0 trillion deficit this fiscal year and a Federal deficit of around $1.0 trillion a year for up to ten years! This is unsustainable, even for the United States.

And, what is going to fuel the further decline in the value of the United States dollar?

Oil prices. And, copper prices. And, gold prices. And, stock prices, And, housing prices. All these are rising now. As these asset prices continue to show strength, the value of the dollar will continue to decline.

On August 2 I wrote a post called “Looking for Signs of a Recovery." In that post I laid out some things to look for in determining whether or not the economic recovery is taking place. Rising asset prices is an important factor.

The trouble with rising asset prices at this time is that these increases are being underwritten by the extremely loose monetary policy. It is entirely possible that these asset prices may continue to rise while real economic growth remains dismal at best. And, in such a situation, consumer prices may not rise appreciably. Again, this is consistent with what we saw in the 2002-2004 period—asset bubbles and only moderate consumer price inflation.

Of course, a scenario that contains a continuing decline in the value of the United States dollar is not a good one for the Obama administration. It raises serious questions about the ability of the Federal government to finance such huge deficits as the ones that are forecast and still maintain relatively low long term interest rates without a major monetization of the debt. This whole scene seems like a replay of the first term of the Bush administration. There is just too much debt in existence.

And, like the Bush administration, the Obama administration is experiencing a reduction in any “good” policy options that are available to it.

Source: Long Term Treasury Yields and the U.S. Dollar