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Analysis: The Fed's Currency Collapse Gambit


Don't worry - this won't hurt a bit.

Editor's Note: This article is by Stephanie Pomboy, of MacroMavens.

This won't hurt a bit.

That, at least, was the assurance offered by the Fed in a working paper that recently turned-up on its website. According to the authors of Currency Crashes in Industrial Countries: Much Ado About Nothing?, we're all far too uppity about the value of our currency. Indeed, the paper concludes that "crashes caused by rising unemployment or external deficits have always had good economic consequences with stable or falling inflation rates."

That's right - your central bank just juxtaposed the words "crash" and "good." In so doing, they've eradicated any scintilla of doubt we might have had that the Fed was willing to risk currency collapse. As I've long argued, when confronted with the Hobson's choice between allowing rates to rise or the currency to fall -- in order to lure creditors to buy more of our increasingly dubious claims -- the Fed was sure to opt for the latter. So sure, in fact, that gold began pricing in this outcome the moment Ben Bernanke put it on the table back in mid-2003.

Recognizing that rates would soon be capped and the dollar left to take the hits, gold made its unprecedented departure from bonds. (See GLD for more data.)

Click to enlarge

Though I do appreciate the Fed's bold ratification of my thesis that the dollar would be the valve for our policy sins, given the choice, I'd prefer to be wrong and maintain our dollar's purchasing power. Being short a PhD against the Fed in this battle of wits, I simply can't manage to fathom how a currency crash could prove painless - much less (to borrow another line from Shakespeare), a consummation devoutly to be wished.

Well… at least not for holders of dollar assets. For dollar debtors, however, it's a paradise. And that's where the Fed's cavalier attitude about a weaker dollar incurs great risk. By openly proclaiming its intent to cap interest rates (and let the currency pay the price), the Fed has sent out a siren call to speculators and debtors the world over to borrow at artificially low rates in a currency being steadily debauched.

Indeed, according to Bloomberg, the share of dollar bonds issued by foreigners has already climbed sharply from 20% last year to 36% last month with everyone from Turkey to the Philippines seizing the opportunity to borrow in depraved bucks.

And the dollar decline has barely begun! Wait 'til the "innocuous" crash comes, and the liquidity flowing out of the dollar valve turns into a deluge. At that point, we suspect the Fed will have a harder time selling the view that a collapse is a non-event - if not here in the US, at least in the emerging markets.

For Ben is about to do unto them precisely what he accused them of doing to us: Inflate their markets on the back of his manufactured "saving glut."
No positions in stocks mentioned.
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