Have Bond Vigilantes Become Dollar Vigilantes?
Have market “vigilantes” — the scourges of U.S. economic policy who in years past drove up Treasurys yields in response to inflation fears — traded in bonds for dollars as their weapon of choice?And if they have picked up the dollar as their sword, they are headed for their final showdown when the Federal Reserve ends its controversial $600 billion bond-buying program in June.
During the late 1970s through the 1990s, bond vigilantes routinely demanded higher yields to compensate for rising prices, cowing U.S. policymakers into curbing budget deficits or hiking interest rates. But the U.S. government’s current unsavory mix of cheap credit and a precarious budget deficit has closed off that path.
The Fed’s bond buying program has suppressed Treasury yields and curbed selling pressure. Also in a world where several central banks are large buyers of Treasurys, vigilantes would not only be fighting the Fed, but also several other central banks.
“What investor will fight the power of a central bank?,” asked Alessio de Longis, vice president and portfolio manager of the Oppenheimer Currency Opportunities Fund. The bond-buying program “may incentivize macro investors to find different vehicles to express” disapproval of U.S. economic policies, he said.
Have the vigilantes pounced on the dollar? The dollar has fallen by more than 10% on a trade-weighted basis since Fed Chairman Ben Bernanke announced the bond buying in August 2010.
The dollar has plunged to multiyear lows against higher-yielding currencies such as the euro, Australian dollar and pound. It has also plumbed a record low against the Swiss franc, sliding nearly 5% in April against a basket of major currencies on its way to its lowest level since July 2008.
“Although the dollar has declined substantially from recent peaks, it remains about 20% above its average level over the last 40 years versus a broad, trade-weighted index,” noted Matthew Gelfand, a senior economist and senior investment advisor at Rockefeller Financial.
As a result, the dollar is not yet at levels that would lead to a loss of confidence in U.S. assets. But should Washington prove incapable of taming its debt-fueled spending and the Fed remain biased toward easy money, the vigilantes would likely press U.S. policymakers.
Before that occurs, “I expect the Fed and the U.S. government are likely to shift gears in the foreseeable future. . . and thus forestall a significant, deleterious drop in the dollar,” Gelfand said.If the vigilantes have moved to the U.S. currency, their hand definitely will be forced when the Federal Reserve ends its bond buying.
They could get caught if the end of ultra-loose liquidity leads to a pent-up wave of dollar buying. John Taylor, chief investment officer at FX Concepts, said the program’s end “should put upward pressure on the dollar, even if interest rate differentials stay exactly where they are.”
But the vigilantes could cash in should the dollar fall into a death spiral if the economy falters or needs even more stimulus once the bond buying ends.
Dollar bears are clearly discomfited by the current U.S. policy mix, but not all market observers think that vigilantes are the culprit.
David Gilmore, a partner at FX Analytics in Essex, Conn., sees the yield differential between Europe and the U.S.–expected to grow wider as the European Central Bank embarks on a monetary tightening cycle–as the single biggest reason why the dollar is falling. Gilmore sees surging stock markets, which have risen on strong earnings, and stable bond markets as a sign that investors have not yet completely lost faith in U.S. assets.
“If those two markets start to weaken because people are losing confidence in the dollar, we will have a rapid change in policy. That would bring forward an exit policy from the Fed,” which would likely start talking up the dollar in order to avoid a run on dollar-denominated assets, Gilmore said.
