Interest Rate Roundup

Monday, November 27, 2006

cent ... five cent ... ten cent ... dollar

My wife and I love cruise vacations -- we've been to the Caribbean and the Bahamas a few times, and hope to do the Mediterranean down the road. One song you inevitably hear the steel drum band play on a cruise has a chorus that goes :"Cent ... Five Cent ... Ten Cent ... Dollar" over and over again, with the pace gradually picking up. It's catchy -- so catchy, you can't get it out of your head for days ... even weeks ... afterward.

I haven't cruised since August. But that darn song keeps popping into my head anyway. Why? It seems to accurately describe how much value our dollars are losing day in and day out. One cent against the British pound here. Five cents against the euro there. It's clearly on the ropes, as I've been discussing on my blog for a while now.

When does it stop? Who knows? The dynamic at work in the currency market (and the interest rate markets) appears to be ...

1) The U.S. economy is weakening
2) This will cause the Fed to cut rates
3) That will narrow the differential between U.S. rates and overseas rates, making the dollar less attractive vs. alternative currencies
4) But bonds are still a "buy" because inflation will ease along with the economy, and the Fed cuts will get rid of the "negative carry" investors are suffering from right now (Borrowing money at high short-term rates and using it to buy long-term bonds with lower yields isn't a lasting path to prosperity)

Here's the problem: A huge chunk of our marketable debt (51.9% of U.S. Treasuries as of June 2006, according to the Treasury Dept.) is held by foreign/international investors. All else being equal, a dollar drop leads to losses on those bondholdings.

So far, it hasn't mattered -- Treasury futures actually set a nominal price high last week. Indeed, waiting for overseas holders to dump bonds due to a dollar decline has been like waiting for Godot. But you have to think at some point, there will be SOME impact on prices and yields. I mean, why should our creditors/debtholders be willing to continue losing money ad infinitum?


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