What Lies Ahead for the US Dollar?

on Jun 11, 2012
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The much-debated US job report for May 2012 caused speculation about another round of quantitative easing (QE3) and a corresponding soaring of gold prices. A new analysis published by the website Seeking Alpha on 8 June 2012 looks into what may lie ahead for the greenback with the Federal Reserve (Fed) expected to take action to boost the US economy.

The analysis author Axel Merk, CIO and President of Merk Investments and manager of Merk Funds, notes that investors can potentially benefit from the recent greenback rally so as to diversify out of the US dollar ahead of the anticipated QE3.
Mr Merk points out that so far the Fed has predominantly solved the US economy’s problems by “sprinkling money” in the form of the previous two QE rounds. More precisely, the Fed bought $2.3 trillion of debt in two rounds since the subprime-mortgage crisis, with these measures being known as QE1 and QE2. According to Mr Merk, the real problem that 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, the securities in question are overpriced by definition. As a consequence, the currency may be expected to weaken as investors look abroad for less manipulated returns.

!m[](/uploads/story/139/thumbs/pic1_inline.png)According to Mr Merk, among the root causes for the lagging of the US economy are the ongoing global deleveraging, the deleveraging of US households as well as the uncertainty regarding the US regulatory and fiscal policy. Yet, the recent unemployment report may provide the incentive for a new round of measures with the purpose of supporting the US economy.

On the basis of the already implemented QE rounds and taking into account the views of the Fed’s chairman Ben Bernanke, Mr Merk looks into Long Term Refinancing Operations (LTROs) as being among the measures most likely to be adopted by the Fed. LTROs have been applied in the Eurozone, with the European Central Bank (ECB) providing unlimited liquidity to the banking system.

As noted in the analysis, the main difference between LTROs and the QE1 and QE2 are that LTROs are demand driven and also, they are profitable to banks rather than the Fed. Yet, since the US banks are not in not as dire state as the EU banks, Bernanke may favour Fed-customised LTROs, allowing banks to turn their illiquid mortgage-backed securities in to the Fed in return for liquidity.

If the LTRO does not work, there are other possibilities as well, with Mr Merk pointing out that Bernanke once noted that the Fed had the authority to buy both foreign and domestic government debt. Yet, such actions are likely to have certain political consequences, which cannot be overlooked.
In the case of an US-style LTRO as a possible initiative, new money might need to be “printed” so as to provide the liquidity offered to the banking system. If that happens to be the case, it will lead to yet further weakening of the US dollar, whereas currencies sensitive to monetary stimulus may shine yet again. Yet, Mr Merk notes that there may not be a safe asset anymore, meaning that investors may consider a more diversified approach to something as mundane as cash.

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