Axel Merk: What’s next for the U.S. Dollar? QE3?

Axel Merk, Merk Funds, has published a new "Merk Insights" newsletter entitled "What’s next for the U.S. Dollar? QE3?" where he discusses the outlook for the US currency.

The dismal U.S. jobs report for May, released last Friday, caused the price of gold to soar as the market appears to be pricing in an ever-greater chance of “QE3” – another round of quantitative easing by the Federal Reserve (Fed). But given that 10-year government debt is already down at 1.5%, the Fed may dive deeper into its toolbox in an effort to jumpstart the economy. Investors may want to consider taking advantage of the recent U.S. dollar rally to diversify out of the greenback ahead of QE3.

To a modern central banker, it may be very simple: if the economy does not steam ahead, sprinkle some money on the problem. The Fed has done its sprinkling; indeed, the Fed has employed what one may consider a fire hose. But after QE1 and QE2, we continue to have lackluster economic growth, unable to substantially boost employment. Never mind that the real problem the global monetary system is facing is that the free market has been taken out of the pricing of risk:

• When the Fed buys government securities, such securities are – by definition - intentionally overpriced. Historically, when a central bank buys government bonds, the currency tends to weaken, as investors look abroad for less manipulated returns.
• Policy makers increasingly manage asset prices, be that by pushing up equity prices through quantitative easing; artificially lowering the cost of borrowing of peripheral Eurozone countries; or by keeping ailing banks afloat.

Investors increasingly chase the next perceived move of policy makers, thus fostering capital misallocation. Policy makers in Spain may not like paying above 6% for their longer-term debt, but lowering such rates ought to be the result of prudent policies, not because of a game of chicken between the Spanish prime minister and other European policy makers (if we only knew who the other chickens were – they are all hiding!). Similarly, U.S. growth is lagging because – let’s just name a few of the root causes - of ongoing global de-leveraging; the de-leveraging of U.S. households; uncertainty over U.S. regulatory policy; uncertainty over U.S. fiscal policy.
But let’s keep it simple, as it doesn’t matter what we think. What matters is what our policy makers do. Bernanke has indicated that the Fed is willing to provide more support to the economy. The latest unemployment report might provide that impetus, especially given Bernanke’s view that “The central bank should act more preemptively and more aggressively than usual.” This quote comes straight from what may be considered Bernanke’s playbook: his 2002 “helicopter speech” on how deflation can be beaten. Last fall, we browsed through the playbook to pose the question: Operation Twist a Primer for QE3? To recall, Bernanke argues:

• Deflation is in almost all cases a side effect of a collapse of aggregate demand….The best way to get out of trouble is not to get into it in the first place…The Fed should try to preserve a buffer zone: …central banks … set … inflation targets … between 1 and 3 percent, … reducing the risk that a large … drop in aggregate demand will drive the economy far … into deflationary territory

When faced with deflation:

• The central bank should act more preemptively and more aggressively than usual…
• Deflation is always reversible under a fiat money system…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost… a determined government can always generate higher spending and hence positive inflation.

QE1 has come:

• The Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

Operation Twist and a commitment to keeping interest rates low for an extended period is also taken from the playbook:

• One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out the Treasury term structure – that is, rates on government bonds of longer maturities.
• One approach…would be for the Fed to commit to holding the overnight rate at zero for some specified period.
• A more direct method, which I [Bernanke] personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities… at prices consistent with the targeted yields... if operating in relatively short-dated Treasury debt [next two years] proved inefficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.
• Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities [MBS] issued by Ginnie Mae, the Government National Mortgage Association).

We had the MBS purchase program as QE1. We don’t think a targeting of longer-term interest rates is in the cards, as rates are already quite low. To see what may be announced by the Fed in the near future, keep reading (emphasis added):

• Alternatively, the Fed could find other ways of injecting money into the system – for example, by making low-interest rate loans to banks or cooperating with the fiscal authorities
• If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities… the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.
• The Fed could offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, amongst others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.

What does that mean? Look at Europe’s Long Term Refinancing Operations (LTROs). In Europe, the European Central Bank (ECB) has been providing unlimited liquidity to the banking system, allowing banks to get liquidity in return for a broad range of collateral. While U.S. banks are not in as dire a situation as European banks, Bernanke may be motivated to provide LTROs Fed style because it would allow banks, such as Bank of America, to turn their illiquid mortgage backed securities onto the Fed in return for liquidity. Key differences to QE1 and QE2 are:

• An LTRO is demand driven. Rather than the Fed buying a colossal amount of securities, unsure of what to do with a bloated balance sheet, the LTRO gets the money where it is in demand. A bank that wants increased liquidity – presumably to invest the money in riskier assets – will be willing to participate in the LTRO.
• LTROs are extremely profitable to banks rather than the Fed. Currently, the Fed earns over $80 billion a year: the more money a central bank prints, the more interest paying securities are purchased, thus the more “profitable” the central bank is (never mind the potentially eroded purchasing power as a result of having printed the money). The ECB, in contrast, only charges 1% in return for cash provided on collateral. Given the near zero interest rates in the U.S., expect the Fed to charge only a nominal amount to turn securities held by banks into cash.

What may hold Bernanke back is that he can’t be sure of the impact a U.S. style LTRO might have:

• One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies.

Indeed, we have been critics of the ECB’s LTRO because over one trillion euros in liquidity will need to be drained within a matter of weeks should the LTRO be closed out. We don’t think this is feasible. However, the reason why these “nonstandard measures” have not caused major inflation is because policies in the U.S. and the Eurozone have not worked – the money doesn’t “stick.” With the U.S. recovery further along than the Eurozone recovery, the risk for Bernanke – and with that to the purchasing power of the U.S. dollar – is that banks will actually use the LTRO to get the economy going. If so, Bernanke claims to be able to raise rates in 15 minutes. We will see about that, especially in the context of his conviction that one of the biggest mistakes during the Great Depression was to raise rates too early. In our assessment, Bernanke must err on the side of inflation if he wants to stay true to his convictions. It’s in that context that he has been willing to commit to keeping interest rates low until the end of 2014; incidentally, by that time, odds are high that much of the foreclosure pipeline will have been worked through thus allowing the Fed to return to more traditional monetary policy. That’s the theory. In practice, little has worked out since the onset of the financial crisis as has been envisioned by policy makers; then again, the Fed is rarely accused of being too far sighted…
In summary, we believe the next major initiative by the Fed will be the announcement of a U.S. style LTRO. Just in case that doesn’t jumpstart the U.S. economy either, we will have to revert back to Bernanke’s playbook to glimpse what else may be in store:

• The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchases by the Fed is several times the stock of U.S. government debt.

This policy suggestion demonstrates Bernanke’s lack of appreciation for the political consequences of his actions. In his speech, he tries to address that:

• I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. Although… it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.

Our read is that Bernanke won’t consider the outright purchases of peripheral Eurozone debt until after the U.S. elections. Even then, such a step may go beyond the bizarre. Then again, what hasn’t been bizarre in U.S. monetary policy in recent years?
Back to the LTRO, such a policy would boost the Fed’s balance sheet yet again. New money would be “printed” to provide the liquidity offered to the banking system. We live in an environment where central banks hope for the best, but plan for the worst. A U.S. LTRO would squarely fit that scheme. In that environment, the U.S. dollar may weaken and currencies sensitive to monetary stimulus may shine yet again. Having said that, we have long argued that there may not be any safe asset anymore and investors may want to take a diversified approach to something as mundane as cash.

Axel Merk: Euro Crisis: Hope for the Best, Plan for the Worst

Yet another edition of Merk Insights entitled "Eurozone Crisis - Hope for the Best, Plan for the Worst", by Axel Merk of Merk Funds where he discusses the different scenario that may occur in the Eurozone amd the consequence for the Euo exchange rate (He expects the Euro to strengthen as short position are unwind).

Here's the article:
 

When Greece’s woes first rattled the markets two years ago, the pundits predicted a collapse of the euro.

The resilience of the euro has been due to a number of factors, not least of which is that the eurozone as a whole has a broadly balanced current account. As such, a misbehaving bond market doesn’t necessarily cause a plunge in the currency, as foreign buyers are not required to fund a deficit or protect against currency weakness.

The euro has also been on the other side of the Bernanke trade: the Fed’s printing of trillions of dollars is a deliberate effort to weaken the US dollar in an attempt to promote economic growth. Conversely, with the European Central Bank showing more restraint, the euro has been stronger, yet that strength has exposed a host of problems.

A similar pattern was evident during the Great Depression, where those countries holding on to the gold standard longer had stronger currencies, but suffered painful fiscal and political consequences of trying to do the right thing.

The focus should be on making the financial system strong enough to stomach potential sovereign defaults. And, as no one else has been able or willing to step up to the plate, the ECB has been forced to take on the task.

By charging only 1 per cent on unlimited 3-year loans, the ECB is allowing banks to reap substantial profits by buying higher yielding securities. This can be extremely profitable. In the US, the Fed brags about handing over $80bn in profit to the Treasury, neglecting to state the fact that the more money a central bank prints, the more securities it can buy and, thus, the greater the interest it earns. The ECB, though, “splits the coupon” with the banking sector, boosting their profitability.

For now, policymakers hope the ECB’s elixir will continue to soothe the markets, but the fear of contagion is still a big concern. With Greece temporarily patched up, the focus may shift again to Portugal, Spain, and Italy. Policymakers in emerging markets have cause for concern, too, as European banks have been a key source of funding for these markets. Emerging market funding is often provided in US dollars, stoking contagion concerns for US markets. Prime US money market funds were all too willing to buy US dollar-denominated commercial paper issued by European banks.

Indeed, central bankers have ramped up their efforts, seemingly planning for the worst. The Fed introduced a currency swap line to alleviate US dollar funding concerns in Europe. The ECB conducted its 3-year long-term refinancing operations (LTROs). The Bank of England provided another dose of quantitative easing. The Bank of Japan pursues its newly anointed inflation target. These are all variations of printing money.

With all major countries printing money, the problems in the eurozone may ease for now. Add to that the large degree of short positions previously built up in the euro that still need to be wound down, and the single currency should do just fine for the time being.

There’s a price to be paid, though: we don’t see how the ECB, in three years’ time, will be able to mop up the trillion-euro liquidity it has provided. The ECB has now introduced a structural rigidity into its monetary policy, akin to what the Fed is faced with. In many respects, central banks have disrupted the natural transition of market-ascribed economic health by imposing their colossal might (balance sheets) onto the markets. This should be alarming. Central bankers are increasingly manipulating rates all along the yield curve.
Such policies take away crucial economic gauges (market-based interest rates across the yield curve) from investors and policymakers. As result, policymakers can no longer rely on these metrics in setting appropriate monetary policy.

Politicians, too, no longer get market feedback to encourage reform. Spain has already indicated it will further soften its budget goals. Yet, without the ECB’s liquidity provisions, the bond market might have responded with its own “encouragement” to run less of a deficit, by selling Spanish debt.

This is not just a European problem. Look at the proposed 2013 US Budget and it becomes clear that, without the encouragement of the bond market, policymakers may have little incentive to pursue fiscally sustainable policies. With its significant current account deficit, the US dollar may be much more vulnerable than the euro should US bond markets act up.
In the meantime, Greece is experimenting with a carrot and stick assortment of incentives. That approach may be doomed to failure as each time a target is missed the ire will be directed at creditors, most notably Germany. To move beyond planning for the worst, Greece and others must learn to own their own problems rather than rely on central banks and other people’s money

Axel Merk: Fed Flying Blind and Poses Risk to the US Dollar

Axel Merk, Merk Funds, published a new "Merk Insights" newsletter entitled "Fed Flying Blind" where he explains that the voice of reason (i.e. "the market"), who is supposed to tell the federal reserve to stop printing money, has been silenced and this poses potential risks to economic stability, as well as the U.S. dollar.

Here's the the full Merk Insights letter below:

Federal Reserve

As the Federal Reserve (Fed) has become ever more engaged in micro-managing the economy, we have moved from rate cuts to emergency rate cuts, to printing billions, then trillions, first to buy mortgage backed securities and more recently, Treasuries. Coming to the realization that talk is cheaper than action, the Fed has since switched gears and “committed” to keeping rates low, initially through mid-2013 and now through the end of 2014. The Fed has a buzzword to describe its policies: “transparency”; instead, you may want to call it the “fear not – we will take care of you” policy. There are reasons the Fed needs to signal that rates will stay low for such an extended period, amongst them: a reasonable person may believe that current monetary policy could be inflationary; a reasonable person may believe that the Fed actually wants to have inflation to bail out homeowners that are under water in their mortgages; finally, a reasonable person may have paid attention to Fed Chair Bernanke when he argued that raising rates too early was one of the biggest policy mistakes during the Great Depression, concluding that erring on the side of inflation is desirable. But “fear not – we will take care of you” is the message: the Fed is introducing an inflation target, providing assurance that inflation won’t be a problem.

The alternative, of course, would be to conduct what we would deem sound monetary policy, so that a reasonable person wouldn’t be concerned about the risks of money printing in the first place. But that’s so yesterday. Instead, the Fed has engaged in Operation Twist, applying the Fed’s firepower to lowering rates further out the yield curve (longer term interest rates). Indeed, the Fed now owns over 30% of all outstanding marketable U.S. Treasuries with maturities of 6-10 years; across the yield curve, from Treasury Bills to 30-year Treasury Bonds, the Fed has accumulated almost 20% of all outstanding securities.¹ These days, the Fed owns more U.S. government debt than China.

As long as there is confidence in the Fed, the Fed’s strategy may pan out, right? Maybe. We don’t even question the motives of the Fed. However, we question the Fed’s ability to conduct policy when its policy makers are blindfolded. We fear that some of the Fed’s most important gauges used to set policy have been taken away, by the Fed itself. As if to prove the point himself, Fed Chair Bernanke told Congress last week that he is puzzled about incoming economic data, unable to explain why the unemployment rate has come down quite so rapidly. Consider the yield curve: typically, yields provide a wealth of information about the health of the economy, about inflationary pressures, to name a few. As such, an important feature of the yield curve is that it can sell off, amongst others, should inflationary pressures pick up or should investors be concerned about long-term fiscal sustainability. With the Fed becoming evermore engaged in yield curve management further along the curve, this gauge has been taken away.
Former Fed Governor Kevin Warsh, a critic of active yield curve management, has said the Fed is looking into the mirror in conducting policy. We agree. Luckily, the folks at the Fed are some of the smartest economists around. Unfortunately, though, they are human and should periodically be reminded that the greatest failures in monetary history have also been conducted by some of the smartest economists of the time.

If it weren’t enough that the Fed is blindfolded, the Administration and Congress are no better off. At some point, bondholders might get antsy about unsustainable fiscal policies. Without major policy initiatives, the non-partisan Congressional Budget Office (CBO) estimates that the U.S. deficit will grow by $3.86 trillion (the 2013-2017 adjusted baseline scenario in the 2013 budget). Should the Administration be able to implement all its policy initiatives, the five-year addition to the deficit would “only” be $3.44 trillion. The math includes $560 billion in additional revenue by phasing out the Bush-era tax cuts. Should Congress find a way to extend those tax cuts, the Administration’s proposals actually increase the deficit by $140 billion over the next five years (our special thanks to our Senior Economic Adviser Bill Poole, who helped us understand a budget that is most challenging to understand, even for experts). The tragedy here is that fiscal deficits are not taken seriously. We point this out not to single out the Administration: neither Congress, nor the presidential candidates, have come up with clear initiatives that would actually put the budget on a sustainable path.

Why not? Because the bond market lets policy makers get away with squandering money. Not so in Europe: Thanks to the “motivation” provided by the bond market, European policy makers are engaged in very serious structural reform. In our assessment, the language of the bond market is the only language policy makers understand. With the Fed’s micro-management of the entire yield curve, warning shots by the bond market may come much later than they otherwise would. As we have seen in Europe, the longer policy makers wait before engaging in reform, the more painful the consequences. Ultimately, the Fed may not be strong enough to fight market pressures, but that may be of little consolidation: unlike the Eurozone, the U.S. has a significant current account deficit. Whereas in the Eurozone, notwithstanding significant bond market turmoil causing political havoc and pain, the euro held up relatively well, surprising most pundits to the upside. In contrast, a volatile bond market may have more dire consequences for the U.S. dollar, as it might be increasingly difficult to encourage foreigners to finance U.S. deficits.

It was in the earlier part of last decade when the late Wim Duisenberg, European Central Bank (ECB) President until 2003, said, “We hope and pray that there will be an orderly adjustment to global imbalances.” – in those days, we were concerned that policy makers were overly reliant on hopes and prayers for solutions. Now, hope and prayer has moved to the forefront of Fed policy making, as the Fed has taken away what we deem are some of the most important gauges used to conduct monetary policy. Unfortunately, hope and prayer are no substitute for sound policy making. Prudent investors, as well as investment professionals with fiduciary duty over client accounts, may want to take this risk into account when allocating within their portfolios.