This morning in an e-mail exchange with Marshall Auerback, I questioned why the U.S. Dollar was rising so precipitously. I do understand much of this has to do with a need to refinance dollar-denominated borrowing by international financial institutions that have been unable to roll over their debt in the clogged credit markets. But, the magnitude of the rise is truly astonishing. I said "Dollar strength is very strange."
Marshall understands that Dollar strength is not strange over the short-term because of liquidity needs. However, it was his analysis of Fed policy that I found most interesting. I will repeat it here:
Well, I don’t consider [Dollar strength] strange, but I do think it gives Bernanke a window to put all of his theories into practice, yet he seems curiously hesitant.
I believe that odds of more financial turmoil are high despite all the efforts of the authorities. Falling income will bring new adverse events in credit. It appears that the CDS market could bring on a new crisis. I believe that there is the potential for serious counterparty risk events coming out of the OTC commodity derivatives markets. And, lastly, news of the hedge fund crisis has been largely suppressed and some absolutely shocking revelations may come soon.
In the current political environment there is nothing that can be done to stop falling dominoes among Wall Street’s most notorious fat cats and this could lead to another crisis in confidence in the policy makers and further overall market panic.
All these could set off another downleg in the stock market. On the other hand, with the Treasury having shot most of the bullets it has for dealing with the financial crisis, the burden of policy response may revert to the Fed. And so it should be according to Fed Chairman Bernanke.
It is ironic that the scholar of the Great Depression and of the Japanese post bubble economy has not moved to a zero policy rate and quantitative easing by now. Bernanke’s studies of both episodes concluded that the policy error of the central banks in both instances was that they failed to go to zero interest rates and quantitative easing fast enough. It was not that they failed to do these things, because both central banks eventually did. The failure according to Bernanke was that they didn’t move fast enough, they waited too long.
But Bernanke himself has been waiting. He went for many months with no change in the federal funds rate until unimaginable financial crisis forced the most recent cut. Even then he waited for the foreign central banks to join him, which goes against his policy prescriptions for the Fed of the thirties and the BOJ of the nineties. It seems to me that if there unfolds a new facet of the financial crisis, whatever is now restraining him will be jettisoned. He will have to go the whole nine yards and with speed.
I believe if this is what materializes in the near future, and I believe it is highly probable — the fact that the Fed is now bent on trashing cash — may catalyze a reversal in the stock market.