U.S. to “Win” Currency Wars?

By: Axel G. Merk, Merk Investments, GoldSeek.com

Currency Wars will most importantly play out at the heart of investors’ portfolios rather than in the blogosphere or on TV. While the focus may currently be on Japan’s efforts to weaken the yen, U.S. investors might be particularly vulnerable. Let me explain.

Currency Wars start at home because the value of the greenback relative to other currencies may be key to investors’ purchasing power. We know the Federal Reserve (Fed) has been busy buying Treasuries and Mortgage Backed Securities (MBS) through their Quantitative Easing (QE) programs. To pay for what is now a portfolio worth over $3 trillion in such securities, the Fed has deployed its “resources” – a fancy name for a computer keyboard, colloquially referred to as a printing press. Intentionally or not, the Fed has helped finance U.S. deficits as the more securities the Fed has purchased, the greater the interest it has earned, allowing it to most recently transfer close to $90 billion in annual “profits” to the Treasury. Of course much of that interest comes from Treasury securities held by the Fed, interest that is then transferred back to Treasury, effectively eliminating the interest the Treasury pays on the portion of outstanding debt held by the Fed (much of it higher yielding longer-term debt). Janet Yellen, current Fed Vice Chair and potential Bernanke successor, recently remarked in a February 11th presentation to the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) that the current (ultra accommodative) policy “is a policy that is not only good for output and employment and American workers, but also for the federal finances overall,” leaving the interpretation open that today’s policy is, at least in part, justifiable on the basis that it helps government finances.

Indeed, as the Fed’s actions have contributed to lower interest rates across the yield curve, the Administration banks on easy money curing its deficit woes: President Obama’s State of the Union Address, presented a slide claiming $500 billion in interest savings, a key contributor to $2.5 trillion in deficit reduction:

It is correct that the cost of borrowing for the U.S. has been declining and may continue to decline in the short-term as higher coupon paying debt matures and is refinanced at lower interest rates. However, in our analysis “Hidden Treasury Risks?”, we showed that the tailwind can easily turn into a substantial headwind.

Last week, I had the honor of moderating a roundtable discussion featuring Philadelphia Fed President Charles Plosser. I asked him whether he is concerned that U.S. deficits might become unsustainable should interest rates rise. Plosser pointed out that deficits at current levels are already unsustainable. To add to the pessimism, in a cover page article published last weekend, Barron’s warned, “if we fail to rein in spending and increase taxes – starting now – the U.S. in 22 years could be in worse shape than Greece is today.”

So why do I refer to Treasuries and interest rates when such talk is not necessary to realize that trillion dollar deficits are not sustainable? And if I may add in that context: policies, no matter how good their intentions may be, that “don’t add to the deficit,” may not be good enough to make deficits sustainable. The reason to consider interest rates is because of the topic at hand: Currency Wars. Consider the following:

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