What is the FED willing to sacrifice?

Weak US dollar vs. Rising bond yields

These are still exciting times in the financial markets and you don't have to be an expert to see that there is still a lot to come.

The US Federal Reserve with its chairman Jerome Powell is currently facing a crucial question. What are they willing to sacrifice?

At the moment, the FED has to weigh up what could cause the bigger damage at this moment. So it's currently called dollar vs. bond yields.

If we follow this criterion, the FED will keep the yields (risk premiums) on government bonds in the basement as far as possible and use the tool of yield curve control, as we are already seeing in Japan, for example.

Yield Curve Control, or YCC for short, means in simple terms that the FED ultimately “freezes” the yield on the corresponding bonds by buying up all government bonds on the market in a fixed price range or does not allow them to deviate from this range.

But what does YCC require?

It requires liquidity, i.e. even more US dollars and going along with that a further growing balance sheet. However, in my opinion, the simple announcement of YCC by the FED would ensure that returns are kept in check. In this context, the FED would continue to buy more and more bonds and so control the yields over the long term. The negative aspect would be to weaken the dollar quite badly.

Why could this be the less worse?

Rising bond yields would be very expensive for Americans. The public deficit continues to rise into negative territory. This would hurt even more if bond yields start to pick up again.

As a side effect, this can also result in more liquidity flowing from equities (i.e. stocks) into the debt market (i.e. bonds).

Here the officials have to ask themself whether they want to risk another price fall on the American stock market and that of all things in the hot phase of the election campaign between Biden and Trump.

Furthermore, a weaker dollar isn't even necessarily bad for an economy at first.

A weak domestic currency makes it more attractive for foreign buyers to import more products, as the relationship between their own currency and the US dollar increases for importers.

Simply said, they get more for their money. Incidentally, this is something from which the European economy has benefited enormously in recent years from a weak euro and which should never be forgotten despite all the criticism from the European Central Bank.

In the USA, however, we have a slightly different basic structure. In contrast to the EU, which is usually characterized by strong export figures, the American economy lives more from strong American consumers and thus domestic demand. So it hurts the American more when the US dollar falls, than when it hurts the European when the euro weakens.

Fiscal policy would therefore have to compensate for these deficits with the necessary means in the form of further stimulus, if they can be reached.

In addition, one must not forget that the US dollar is the so-called “world reserve currency”, i.e. the majority of global debt is held in US dollars. So at the moment it is actually a good situation for foreign borrowers, as they are more likely to benefit from a weaker dollar and to repay their debts even better.

So in fact it becomes “cheaper” for debtors which use the dollar as the base currency for their debts.

On the contrary, I think that a continued dollar strength is currently the greater risk, as the global mountain of debt continues to grow and grow and it then becomes “more expensive” to pay off US dollar debts, especially in the Emerging Country area.

What my conclusion is

I think that the FED is ready to let the US dollar depreciate further due to the dollar strength of the past few years.

If you look at the long-term development of the US dollar, you can see that the currency has had a strong rally in recent years and that a certain price slide is more than justifiable from a technical point of view.

One should not forget, however, that I am reporting on a paradoxical situation here, since the entire development of the financial markets is increasingly focused on the decisions of the Fed. Others are welcome to philosophize about whether that will work out in the end.

What one should definitely pay attention to at the moment is the correlation between US dollars and bond yields. If yields rise, the USD rises and vice versa.

© 2021 by Lukas Kuemmerle

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