In a normal world these two charts would be complementary. As interest rates on the 10-year Treasuries rise one could reasonably expect the Dollar Index to follow. But ever since March18th when the Federal Reserve announced its $300 billion quantitative easing policy, the divergence has been pronounced.—the higher Treasury rates climb the lower the Dollar Index sinks. Has the natural order of the currency markets been upended?
10 Year Treasury Yield 1 Year Chart
Dollar Index 1 Year Chart
In normal economic times the currency market and the bond market respond to the anticipation of higher US rates. The price of Treasuries fall, the yield climbs and the dollar gains. It is the expectation of returning economic growth and inflation that piques the anticipation for a new upward rate cycle from the central bank. If this were a standard recession, with three quarters of negative growth already past, historically low rates, large amounts of additional liquidity, and the first stirrings of recovery, market anticipation would focus on the changeover to a restrictive rate policy.
But these are not normal times. Fed rate policy is constrained by the recession and the residue of the financial crisis. The Fed cannot and will not raise rates until the economy is clear of the threat of deflation and the financial system has restored its ability to lend and supply credit to the economy.
The Fed is in a bind. If it lets consumer interest rates rise it undermines the economic recovery its policy has been trying to foster since last year and risks choking off whatever economic stabilization has been achieved. But if it increases its purchases of Treasury debt to keep rates low then it provokes fears of future inflation; and, what is perhaps more damaging, the suspicion that the US government is willing to monetize its debt.
In the current economic environment, and especially in light of the government’s unprecedented funding needs, extensive Fed purchase of government notes, quantitative easing, will cause as much harm as good. ‘Quantitative easing’ is simply a different term for the monetization of government debt. The Federal Reserve buys debt issued by the Treasury and the Treasury uses the proceeds of the sales to pays its bills, which means distributing the new dollars to the economy.
The inflationary result of quantitative easing is twofold. It contributes directly to present inflation by increasing the money supply and by devaluing the dollar, raising the cost of dollar priced commodities like crude oil. Higher oil prices feed back into consumer price inflation. Last summer’s $4.00 a gallon gasoline was at least partly caused by the historically weak dollar. The cost of gasoline acts as a direct drag on consumer spending, reducing disposable income. The pump price for a gallon has gained more than the dollar in the past two months.
The second effect of quantitative easing is more insidious but in the long run far more damaging to the US dollar. If higher rates for US Treasuries indicate an oversupply of these dollar assets then they pose a danger to the dollar’s status as the world’s reserve currency. One of the basic functions of a reserve currency is as a store of value for liquid assets. If investors look into the future and see only an ever increasing supply of dollar assets for sale, in numbers far beyond the rate of economic growth in the US, issued by Washington to fund its deficits, then the value of those assets will likely to fall..
The financial crisis was a singular event and it prompted an unprecedented flight to quality in the Treasury market. The demand for security was so great that Treasury yields fell far below historical analogues. Two developments particular to the Treasury market and abnormal in the sense of never having occurred before have kept the currency markets from responding in a standard fashion to the rise in Treasury rates.
First, the recent increase in the 10-year yield has taken place in the contest of historically low Treasury rates. The 2.03% yield of last December was an anomaly and the return to more normal yields should not be taken to mean anything but that the most extreme portion of the financial crisis is passed. Higher Treasury yields do not in this case mean a change in Fed policy is near.
10 Year Treasury Yield 20 Year Chart
The second Treasury market development is also brand new and without historical example: the budget plans of the Obama administration.
The Democratic administration isn’t just issuing record debt this year. For the next ten years, in the government’s own projections, deficits never drop below $500 billion in any year. The administration claims that this scale of debt is necessary to help the US avoid the worst effects of the recession. But the costs of the array of new programs that are part of the budget projections dwarf anything that the US government has ever enacted before. Every dollar of this new spending will have to be borrowed.
For the Treasury market the vast supply of issuance threatens to overwhelm demand. This quantity of government debt has never been put for auction to the world’s investors. Their response is unknown. Will the United States government be able to sell its debt and fund its deficit? Yes. The question is at what cost. How much higher will returns have to go to keep buyers purchasing US securities?
In pushing Treasury rates higher, the bond market is responding to the enormous pending supply of government debt and to the historic lows in Treasury yields that resulted from the financial panic. 3.7% yields in the 10-year Treasury are not indicative of a Fed on the verge of a restrictive interest rate policy. .
Because both developments were singular to the Treasury market and do not yet represent a scenario dangerous for the US economy the currency market response was muted. It remains to be seen if currency traders view the projected massive increase in American debt as a positive or negative for the dollar.