The US Federal Reserve’s announcement of a massive programme to buy back bonds and mortgage securities has sent US bond yields plummeting and the dollar plunging. Part of the reason for the Fed’s decision could lie in the data on cross-border financial flows to the US put out earlier this month by the treasury. As economist Brad Setser has pointed out, foreign buying of US long-term securities has been lower since November, but it fell dramatically in January.
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This is significant as the US government is undertaking a huge fiscal stimulus plan that calls for selling vast amounts of government securities to fund it. But if foreign appetite for US securities diminishes, who will the US government sell its securities to, particularly if local savings do not rise to the necessary extent?
In that event, bond yields will have to rise, which is something that the US government will wish to avoid at all cost in the current environment. The way out would be monetization, that is, the Federal Reserve could buy the securities, expanding its balance sheet.
This is, perhaps, the only feasible course of action left, because with diminishing current account surpluses in countries such as China and a current account deficit in Japan, the scope for these countries buying large quantities of US paper is also diminished. The Fed’s action, called quantitative easing, amounts to printing money. Small wonder the knee-jerk reaction was to sell the US dollar.?The?British?pound?was also punished earlier, when the Bank of England announced quantitative easing.
Recall, though, that this is not the first time the dollar index has rallied in recent months. After reaching a high in November, the dollar index tumbled, falling to a low in the middle of December before clawing back lost ground. Thereafter, after scaling a new high at the beginning of the current month, it has been steadily falling, before Wednesday’s announcement by the Fed hastened its fall.
But if foreign purchases of US securities fell in January, why did the dollar strengthen during that month? Analysts say it was probably because swap lines by the Fed to other central banks contracted in January, repatriating funds to the US.
Whether the dollar strengthens or not is of great importance to all those Indian companies with big dollar loans on their balance sheets. Dollar bulls have pointed out that the euro is no alternative, but, as Morgan Stanley’s Stephen Jen has recently said, the euro should gain from the decision to augment the International Monetary Fund’s resources, which will go towards bailing out Eastern Europe, thus strengthening European banks.
Nevertheless, much will depend on whether the European Central Bank too is forced to get into quantitative easing mode. If it isn’t, dollar weakness should continue. The dollar benefited from the deleveraging panic during the last quarter as investors rushed towards the supposedly safe US haven. Hopefully, the worst of the deleveraging is now behind us and more fundamental forces will now take precedence, leading to a weaker dollar. That will, of course, be positive for both gold and commodities.
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Graphics by Paras Jain / Mint