Fed Policy to Drive U.S. Dollar Lower to Prevent Deflation

By: Axel_Merk

Faced with the threat of deflation, the Federal Reserve (Fed) may be trying to drive the dollar lower to spur inflation. As policy makers don't want home prices to deteriorate further, an alternative is to inflate the prices of all other goods and services: as a result, the relative prices of homes would be less expensive. Weakening the dollar is an effective policy tool to drive up inflation as the cost of import goes up. Just be careful: the Fed may be getting more than it is bargaining for.

Fed Chairman Bernanke believes that a weaker dollar will only drive up inflation modestly; in our humble opinion, we believe he may be mistaken. Foreigners have a limit on how much margin pressure they can absorb before they have to pass on the higher cost of doing business. We saw this phenomenon in the spring time, when higher commodity prices forced Asian exporters to drive up prices; import prices into the U.S. were up over 20% year over year (and still up substantially after factoring out what was soaring oil prices at the time). No country has ever depreciated itself into prosperity and the U.S. is unlikely to be the first.

The Fed has been progressively more aggressive in attacking the dollar. Low interest rates are the traditional policy tool to make a currency less attractive. Short-term interest rates are now at historic lows; interest rates set by the market rather than the Fed are even lower.

Since late September, the Fed has been flooding the banking system with liquidity. By creating money with its printing press, the Fed literally provided hundreds of billions of dollars to the banking system. The Fed does so by buying assets from banks. At first, the program was partially "sterilized" as the Fed provided good quality bills in exchange for whatever the Fed received from the banks. Since then, however, the Fed no longer mops up the liquidity in such transactions and simply provides cash to the banks. Banks, rather than using the money to lend, have hoarded the cash. That's why some observers claim these actions have not been inflationary as bank reserves are increased, but the money supply in the economy is not. Excess reserves in the banking system, traditionally less than $2 billion, are now about $600 billion.

We believe the excess reserves by the banks will be lent to the public, not private sector. While some money is starting to be used for lending (Verizon was recently able to receive a $17 billion loan to refinance debt in the largest debt offering this year), we believe banks continue to be too weak and don't think the private sector is strong enough either. Further, the unprecedented amounts that need to be financed next year by the U.S. government will crowd out the market: there may not be enough money for the refinancing of U.S. corporate, European corporate or emerging market corporate and government debt available, keeping the cost of financing high for all those players.

The Fed will be aggressive at lending to those sectors of the economy where it wants to see borrowing costs low. The Fed has announced it will buy agency securities (Fannie & Freddie mortgage securities to keep the cost of home ownership low), Treasury bonds and, according to the Fed minutes released December 16, 2008, will "consider ways of using its balance sheet to further support credit markets and economic activity." Using the balance sheet means to issue cash created on a keyboard to buy assets in the markets.

As the Fed buys assets in the market, the Fed drives prices higher; in case of debt securities, the yields will be driven lower. Superficially, this will be perceived as good news as the cost of borrowing is kept low for those who are affected by the purchase programs. For example, mortgage rates may remain low. Note, however, mortgage rates are low for those who qualify for a loan, not for everyone. While many are euphoric that the Fed keeps the cost of borrowing low, there are potentially severe unintended consequences. Specifically, through its direct purchases of securities, asset prices are artificially high. Why would private sector participants buy these securities?

The Fed risks becoming the backstop of all economic activity with its action. While the Fed has the printing press, it does not have unlimited manpower: there may already be more acronyms in the Fed's toolbox than staff members. The Fed cannot replace 8,000 banks, but is on its way to doing so. Think of the credit markets: by providing companies like GE direct access to the Fed for its commercial paper needs, GE is kept afloat, but the credit markets remain seized up. The Fed urgently needs to rework its programs to encourage private sector participation, rather than substituting private sector activity.

Importantly, foreign investors are also told their money is not welcome. Foreigners in recent years have been buying the bulk of U.S. Treasury and agency debt. But if these prices are driven artificially high (the yields artificially low), at the very least on the margin - foreign buyers may abstain. Further, Asian investors in particular need their money at home as a domestic stimulus within China is far more efficient than to try to prop up the U.S. economy with debt purchases. The Fed may be able to keep the yield on securities low, but it does so at the expense of the dollar.

The Fed is faced with far greater challenges than Japan. In Japan, there were few foreign creditors. Further, in Japan, all yields - both government and corporate - were low. In the U.S., while the cost of borrowing for the government is low, the private sector is faced with very high financing costs. Rather than the "quantitative easing" that we saw in Japan where the Bank of Japan targeted the reserve levels at banks, we will see a "qualitative easing" in the U.S., where the Fed is going to be closely involved in allocating credit to sectors of the economy it wants to stimulate. This sort of interference with market prices will have unintended consequences, costly side effects. In our view, these will play out in the currency markets. Watch that dollar carefully.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com .

By Axel Merk

Chief Investment Officer and Manager of the Merk Hard and Asian Currency Funds, www.merkfund.com

Mr. Merk predicted the credit crisis early. As early as 2003 , he outlined the looming battle of inflationary and deflationary forces. In 2005 , Mr. Merk predicted Ben Bernanke would succeed Greenspan as Federal Reserve Chairman months before his nomination. In early 2007 , Mr. Merk warned volatility would surge and cause a painful global credit contraction affecting all asset classes. In the fall of 2007 , he was an early critic of inefficient government reaction to the credit crisis. In 2008 , Mr. Merk was one of the first to urge the recapitalization of financial institutions. Mr. Merk typically puts his money where his mouth is. He became a global investor in the 1990s when diversification within the U.S. became less effective; as of 2000, he has shifted towards a more macro-oriented investment approach with substantial cash and precious metals holdings.

© 2008 Merk Investments® LLC

The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds owns and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard and Asian Currency Funds. Foreside Fund Services, LLC, distributor.

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