Originally posted at AgilityForex.com
Is the U.S. treasury market reading the tea leaves correctly? Today, the short end of the U.S. yield curve moved higher, signaling a rise in rates faster than most analysts are forecasting after the Fed released the FOMC minutes yesterday. Janet Yellen also jumped into the fray, saying that the Fed and the futures market were not that far off as far as the timing for a shorter term rate rise. The USD spiked higher in response to the Fed’s comments, also signaling a higher curve in the near future. The equity markets popped the champagne and closed again in record territory, betting the Fed has months to go before they pull the trigger. All of these markets can’t be right. I’m betting on the bond/FX market. Rates will be going higher faster than most people expect. This will spike demand for the dollar at a time when China is easing, fearing an economic slowdown, and the ECB is launching another round of QE.
We have a classic tug-of-war going on as far as the dollar is concerned. On one hand, due to the Fed’s QE sugar-high, the U.S. economy is recovering, albeit slowly. The U.S. currently seems to be the only game in town as far as growth is concerned. Europe is stagnating under the chokehold of socialistic policies. China is battling misallocation of capital, lowering rates, and pumping money into state-owned banks. Russia is most likely in recession. The dollar is the lesser of many evils. As rates rise, there will be more demand for the greenback which can still claim to be the world’s reserve currency.
On the other hand, the United States is still spending much more money than it brings in. Despite the short-term improvement in the U.S. budget deficit due to better economic growth, the gap is forecast to rise significantly in the near future as the population continues to age and Obamacare kicks in. The Fed is scheduled to end its bond buying program or quantitative easing (in South America they still call it printing money) over the next few quarters. As the debt continues to rise, approaching twenty trillion dollars on its way to thirty trillion, the full faith and credit of the United States government could be called into question. The Fed could well lose control of the bond market and long term rates could spike as well. Each one percent rise in medium term rates in the U.S. is about $200 billion in debt service cost. This could easily turn into a vicious spiral as the world reevaluates America’s ability, and more importantly, her will to pay back the money she has borrowed from the global community. This could seriously negatively impact the reserve currency status of the dollar in the medium to long term, which would reduce the bid the greenback has enjoyed for decades, since the end of World War II.
The bottom-line is that while in the short run, the dollar is the only game in town as far as reserve currency status and economic growth are concerned, there are clouds on the longer term horizon. Investors can probably ride the short term wave in the dollar but need to be mindful of political, monetary, and fiscal developments over the coming few years to really understand what’s in store for interest rates and FX rates involving the U.S. going forward.