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The Fed's Strong Dollar Problem

Ain't such a problem after all. Not like the weak US data...
MARC CHANDLER is global head of currency strategy at Brown Brothers Harriman.
Here he speaks to Hard Assets Investor's Mike Norman about the latest developments in the currency markets, including gold.
Hard Assets Investor: What's going on in the currency markets? The strength in the Dollar has surprised so many people – and it has had a huge effect on commodities and raw materials and economies throughout the world.
Marc Chandler: So in the big picture, I think what we're really talking about is one word: divergence. The Federal Reserve was very aggressive early on after the financial crisis, and more aggressive than other central banks. And now, several years later, that's producing separate outcomes. The US is ahead of the curve. The US economy is bigger than it was before the crisis. And the Federal Reserve, I think, has a tightening bias. It wants to raise interest rates, looking for the opportunity.
Meanwhile, from the ECB, people have anticipated what they're doing; that is, negative interest rates and quantitative easing. And the Bank of Japan is also doing massive quantitative easing. Most recently, China also looks like it's considering some kind of quantitative easing. This, I think, is going to underpin the Dollar, not just now, but on a trend basis, even though the first quarter was a very strong quarter for the Dollar, one of its best in a floating era.
Here in Q2, while they're getting some consolidation, I think that might continue until we get some more convincing evidence the Fed will have an opportunity to raise interest rates later this year.
HAI: That begs the question: How much of that rate move – if and when it happens – is already baked in?
Marc Chandler: I just don't think that, on these kind of things, it can be really priced in. Germany is offering negative interest rates; that is, you want to give your money to the German government, they charge you for the privilege.
So it might have been a portfolio adjustment, this kind of development. But now, what do you do with the incremental savings? What about a fund manager? What about sovereign wealth funds, central banks? They have Euro bonds. And what do they do with them? Do they just see the Euro decline and the bonds peak out in value as the yields continue to fall?
I suspect this kind of thing cannot really be priced into the market, partly because we don't know how far this divergence is going to be. We thought zero would be the bottom for interest rates. And here we are, with many countries in the Eurozone now having more than minus 20 basis points on short-term borrowings. Even a country like Spain – which a few years ago was going to the ECB for extra assistance – has now been selling three-month and six-month bills with a negative yield.
HAI: There's infinitely more risk in a country that doesn't issue its own currency. Yet the markets are not pricing it that way.
Marc Chandler: I think you speak to two issues. One, I think some people think that, because the US Dollar is the No.1 currency reserve asset, that the US can borrow money cheaper than other countries. Factually not true. Germany, as I mentioned, and other countries in the Eurozone already raise money cheaper than the US. But I'm not so sure how irrational it is. I think this is the way the system works.
Imagine you're a bond fund manager, and you have to track an index. So do you promise your investors relative returns – not absolute returns – relative to the index? And now the index will have German Bunds in there. It will have other European bonds in that index. And if you don't buy them, even with a negative yield, you're going to underperform your benchmark. My fund attracts a benchmark, does better. I get the funds, you're out of a job.
HAI: Speaking of bond fund managers, one very famous one, Bill Gross, said being short the Dollar is the greatest trade he thinks this year. And he said being short German Bunds is the greatest trade of a lifetime. I know he's been wrong recently quite a bit. But what do you make of that?
Marc Chandler: Well I don't know. I think there's room for a contrarian trade. The Euro bottomed just below $1.05 and we bounced up. I think we're stuck in a trading range, not a trending market now. And it requires different sets of technical tools to use for market participants trying to catch a range, rather than a trending market. People have been talking about Japanese government bonds as being a good widow maker.
HAI: That's been the case for 20 years.
Marc Chandler: Exactly. I think it's made a lot of widows then. We still talk about Japanese bond yields, about 25 basis points on a 10-year. Germany is significantly below that now. I just think that, with the ECB buying European bonds, and a shortage of German Bunds, because the German government is not just pursuing a balanced budget this year, but a budget surplus, perhaps. But they're also paying down older debt.
So I just think that there is a shortage, because German Bunds are also used as collateral. With the prospects of Greece maybe exiting, I don't think so, but the pressure remains on Greece. ECB buying bonds, Bunds, I think it's too early to pick a top on the German bond market. I think a 10-year yield will go negative. And we're still in positive territory.
HAI: Wow. Now you alluded to the Dollar being the global reserve currency. There have been a lot of people who have been predicting, for a long time, that that's going to end. What do you make of alignments like Russia and China, starting to link up and use their currencies in exchange for oil and trade?
Marc Chandler: I don't think it'll have much of an effect in the big picture. Global reserves are something like $11 trillion. There's not enough Chinese assets that the world can buy, because China needs to give us permission to buy their assets. There's not enough of this permission to replace the Dollar.
I think that China sees in Russia the same thing that investors do: a big gas station, big oil facility. China needs resources. It can get those resources from Russia. If they make the trade in Russian Rubles or Chinese RMB or potatoes, it doesn't really matter. The lower the Dollar, the depth of our Treasury market is second to none.
The reason the Dollar is no longer going to be the top reserve currency in the future is not because China and Russia have an energy deal. Some of these parallel organizations China is creating are important. I think the US has misplayed its hand with the Asian infrastructure investment bank. There are other issues coming up this year.
I'd say the first thing, in May, is that China will likely give its citizens deposit insurance, which is something we take for granted since the Great Depression of the United States, something that they're wrestling with in Europe. China is just going to reintroduce deposit insurance probably in May.
Same time, China wants to be included in the SDRs, that's the special drawing right, the basket of currency that the IMF uses. It cannot be in that basket unless it adheres to certain rules, including telling us how much gold they have. Some people are suspicious that they haven't updated their official gold holding since 2009. Some people suspect they have been hoarding a lot of gold, like Russia has been buying a lot of gold recently.
HAI: Right. But isn't that to sort of reduce their Dollar holdings – they're selling Dollars, buying gold?
Marc Chandler: That might be the way Russia is doing it. But I don't think that's the way China is doing it. China knows the same thing that we know – that some of these Dollar perma bears and these gold bugs don't appreciate – and that is, Chinese officials say, "We cannot put more than 2% of our reserves in gold, 2% of reserves, because the gold market, at current prices, is so small." China has $3.8 trillion of reserves. How much can the gold market take? I suspect they've probably told us the truth: They're not going to have more than 2% of those reserves in gold.
HAI: How much do you think the strong Dollar is keeping the Fed from changing policy, to go to a tightening stance after seven years?
Marc Chandler: Well I'd say that the Federal Reserve has a policymaking equation, if you will. The Dollar is one of those factors. The Dollar had a huge move in the first quarter, so it makes sense that Fed officials watch the Dollar closer than maybe they have in the past. However, I don't think it is the deal breaker.
Why? People like me who thought the Fed would raise rates in June, and now pushed out until September, it's not because of the strength of the Dollar, it's because of the weakness in the economy. And here's an interesting thing. First quarters of the last five years have been notoriously weak. You add up these last, from 2009 to 2014, first quarter, average annualized growth, 0.6%. The rest of the quarters, 2.8%. So I'd say that one of the things that made the Federal Reserve have second thoughts about the timing of the hike, not so much in June, is that the economy slowed down more than they anticipated in Q1.
Secondly, I think that they are perhaps spooked a little bit by that weakness we saw in the last jobs reports. But I expect this next jobs report to be a strong rebound. But I think primarily, the reason the Federal Reserve hasn't really hesitated is that it's continuing what they told us they would do. They have completed the tapering [of QE to no new bond purchases]. They have moved towards looking for an opportunity to raise rates. They're looking for that opportunity. That opportunity likely is going to come late in Q2, early Q3, when the resilience of the US economy shows itself again.
HAI: It does seem like they're buying into this argument that zero rate policy is artificial. But they want to be sure that they see the numbers first. Would that be a correct assessment?
Marc Chandler: I think so. I think that the Fed knows they have been one of the factors that have kept interest rates low. I think that they're not talking about very aggressive rate hikes. Remember, right now, the Fed funds is zero to 25 basis points. The Fed has a range. The first hike will bring us to 25 to 50 basis points as a new range. I think the Fed wants to be careful about that, but it's not going to be like 1994, where the Fed was very aggressive about raising rates. Nor is it going to be like 2004, when the Fed hiked 25 basis points at every meeting. I think they want the lift-off but very slow after that.
HAI: So it sounds pretty much like status quo for a while.
Marc Chandler: For the time being.
HAI: Marc, always great to have you. Thank you. is a research-oriented website devoted to sharing ideas about investing in the natural resources sector. Published by Van Eck Associates Corporation, the site offers an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures, and gold – the three major components of the hard assets marketplace.

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