What to be Watching.

Wednesday showed that words from the FOMC regarding QE will dominate markets. I think that the worst part of this decrease in the rate of expansion of money supply (tapering) is that it could drag on for a year and create a continuous series of doubts as to when QE would end and extend the long-term Treasury bear market for many months. The pain would be lessened if the Fed ended QE rather abruptly. The only positive effect of QE been an equity bubble and the wealth effect created thereby but we all know what happens to bubbles.

The fact is this: mortgage rates move in harmony with Treasuries. If the Fed stops buying Treasuries and in China stops buying Treasuries there is no telling where yields will go. For now they remained contained by the absence of inflation but Treasury prices, because of QE, do not represent values we would have in a real market situation. This is a market with price supports.

I could imagine a situation in which MBS prices start moving on their own irrespective of Treasuries. I am not saying that will happen. I am thinking that might happen.

The key thing to pay attention to may be the Forex value of the UD$. If the US$ starts losing value, inflation will ensue. Underlying domestic economics indicate that we should have little inflation. A loss of US$ value will completely undermine that. The value of the US$ could decrease it the money supply keeps increasing especially is it keeps increasing by $1 trillion a year.

The point is that with inflation contained by a domestic economy with low GDP growth and a barely keeping pace with population growth jobs market inflation may be induced by what is eventually judged to be bad monetary policy resulting in the loss of dollar value relative to other currencies.

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The US Dollar as the Reserve Currency

Since I cautioned above that one should start be be vigilant regarding the possibility that QE could have the effect of weakening the US$ I think it is time for me to start paying more attention to the value of the dollar and also to remind folks the massive importance that the US$ has as the world’s reserve currency.

Let define a few terms:

Fiat currency

Fiat currency is currency created by governments and decreed to be legal tender in the country run by that government. Fiat currency has no intrinsic value. The government does not, for example, guarantee that it can be exchanged for precious metals. The end of convertibility to gold happened in 1971. First West Germany left the Brenton Woods system. Then Richard Nixon ended the convertibility of the U$ dollar into gold. The result was that by 1976 all of the world’s major currencies were floating relative to one another.

The result is that the Federal Reserve can create as much money as it wants whenever it wants. The importance of this cannot be underestimated.

Reserve Currency

A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for commodities.

The fact is that the US dollar has long been “the” world’s currency.” Almost all commodities are traded in US dollars and countries in various parts of the world price their trading in US dollars. Why? Realistically there are only three important currencies in the world: the US $, the Euro and the Chinese Yuan. One of the less obvious advantage of trading in dollars is that there is an enormous set of markets for dollar denominated securities. It is extremely easy and cost effective to hedge exchange risk if the trade is made in US $. Not only are these markets large, they are also liquid. When there is a crisis, liquidity is paramount.