Wednesday, May 11, 2011

Facts Versus Complacency in Currency Markets: Reaching a Dangerous Crossroad

Dollar against trade-weighted currency basket - or how to debase a currency (click on the graph to magnify)

Axel Merk writes a very interesting article in the Financial Times about the state of currency markets. His analysis matches most of my own insights on what has been going on. First, he explains the dollar weakness despite the fact that there's a debt crisis going on in parts of Europe:
Imagine a country that spends and prints trillions to patch up any problem.

Now imagine another country where there is no central Treasury, meaning that bail-outs are less easy, and which has a central bank that’s mopped up liquidity over the past year, rather than engage in quantitative easing.

Why does it surprise anyone that the latter, the eurozone, has a stronger currency than the former, the US? Because of peripheral countries’ debt refinancing issues? And the potential for contagion? These are real and serious issues, but in our assessment, they should be primarily priced into the spreads of eurozone bonds, not the euro itself.
Then he explains, among other reasons, why so many believe that Ben Bernanke lacks intellectual credibility as monetary authority:
Think of it this way: in the US, Federal Reserve chairman Ben Bernanke has testified that going off the gold standard during the Great Depression helped the US recover faster than other countries. Fast forward to today: we believe Bernanke embraces a weaker currency as a monetary policy tool to help address the current state of the US economy. What many overlook is that someone must be on the other side of that trade: today it is the eurozone, which is experiencing a strong currency, despite the many challenges faced within the 17-nation bloc.
He concludes by stating that, due to the monetary and fiscal policy mistakes that have yet been made, it's going to be very hard for the US to avoid high inflation in the medium to long term:
In the US, the day investors come to the reality that inflation, rather than fiscal discipline, is the path of least political resistance may be the day the bond market won’t be as forgiving. Unlike the eurozone, where consumers stopped spending and started saving a decade ago, the highly indebted US consumer may not be able to stomach higher interest rates. The large US current account deficit also makes the dollar more vulnerable to a misbehaving bond market than the eurozone.

In the medium term, we are far more concerned about risks to the US dollar than those posed by the Greek drama to the euro.
No matter what happens, one thing is clear: a financial crossroad has been created where many investors will heavily gain while many others will heavily lose.

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