I am a grizzly bear on the euro for reasons that I have elaborated on in Asia Insider for months, so I was a little surprised to see it go from 1.18 to 1.40, even as many problematic sovereign debt markets in the Eurozone continued to deteriorate. This simply makes no sense.
But, in a world where printing money is done at the click of a mouse and ink is just a figure of speech, the move in exchange rates was more a function of central bank balance sheet pregnancy than anything else.
As the Federal Reserve balance sheet grows, more Treasury bonds get taken out of the financial system as more electronic dollars enter it. Those crispy electronic dollars, directed by the financial institutions that have tendered their Treasury bonds to the Fed, go chasing after other forms of debt. Some say the freshly-minted cash chases stocks too.
How otherwise to explain 24 consecutive weeks of domestic mutual fund outflows, now topping $80 billion, with rising stock prices?
In the end, it is an understatement to say that the circulation of dollars has dramatically increased. This is why its exchange rate against currencies like the euro, which have less aggressive central bankers in charge, has declined. This is also why precious metals have rallied.
The rally in the higher-beta precious metals — such as silver, platinum and palladium — had stalled up until mid-summer until the Federal Reserve announced that they will reinvest the prepayment of their MBS portfolio into Treasuries. This was the catalyst for the massive move in the precious metals sector.
I was certainly wrong to expect a bigger correction in silver, investable via the iShares Silver Trust (NYSE: SLV), as I underestimated the resolve of the Federal Reserve to decimate whatever has been left of the U.S. dollar. Other higher beta precious metals like platinum and palladium — investable via the ETFS Physical Platinum ETF (NYSE: PPLT) and the ETFS Physical Palladium ETF (NYSE: PALL) — responded too…
So what should we expect going forward? Well, as we await the announcement of the second stage of quantitative easing dubbed QE2, we have to consider than such a monetary medicine has never before been tried on such a scale. A monetary overdose is clearly a possibility in this case, because right now the patient is not responding to the treatment.
Right now there is another interesting dynamic at work: As interest rates move lower, Fed MBS prepayments rise, creating more demand for Treasuries and pushing rates down further. This in turn creates more prepayments and follow-on demand for Treasuries.
This controlled cycle is what the central bank is targeting — but it may turn out to be a vicious cycle because I have difficulty seeing the smooth unwinding of this monstrous balance sheet. Who exactly do you sell trillions of debt to? The Chinese don’t seem as willing to buy more. And the fact is that there is no one else.
QE2, if it comes, will mean higher prices for both Treasury bonds and precious metals for the time being, however absurd it may seem. I don’t believe in the sustainability of such monetarist shell games, so the outcome down the road is unlikely to be benign. If given the choice to hold only one of the three — bonds, stocks, or hard assets (like land, bullion, etc.) — for the next 10 years, I will go with the hard assets without a blink.
However, this Fed-created excess liquidity is also helping investors in emerging markets in the short term, as money tends to flow where the best fundamentals are. This is why the best-performing global markets right now are in Asia and South America.