Fed rhetoric could prompt dollar selloff

LONDON: Asian central banks, sitting on trillions of US dollar assets, must be growing increasingly concerned by the tone of the rhetoric emerging from policymakers at the US Federal Reserve.
The Fed seems to be both arguing for stronger emerging market currencies (and by extension a weaker dollar) while simultaneously exhibiting less concern about US inflation as they concentrate on lowering the jobless rate.
That is a potential double whammy for these foreign holders of US Treasuries.
On one hand, a weaker dollar against emerging Asian currencies, which US Fed Chairman Ben Bernanke seems to be advocating, would mean Asian central banks taking an exchange rate loss in local currency terms on any future exit from the position.
On the other, Fed tolerance of slightly higher inflation could hit the capital value of their investments if the bond market eventually demanded higher yields for holding US debt.
As higher yields mean lower prices, existing sovereign holders of US paper would be looking at a capital loss, even as their real return was being eroded by inflation.
Some Asian central banks might decide discretion is the better part of valor and start trimming their US holdings before the situation developed to their disadvantage.
As all traders know, when it comes to exiting a position that looks like it is moving out of court, the first cut is the cheapest. In other words — he who hesitates may be worse off.
That would weigh on the dollar generally and against emerging Asia in particular.
The Fed’s comments speak for themselves.
Chairman Ben Bernanke made a clear call on Sunday for certain emerging markets to allow their currencies to rise.
“The perceived advantages of undervaluation and the problem of unwanted capital inflows must be understood as a package — you can’t have one without the other,” he said in Tokyo.
You also cannot have a stronger emerging market currency without a weaker US dollar. That is one of the offsets.
Traders may conclude that Bernanke is calling the US dollar weaker, even if he would reject the notion.
Further, three top Fed officials are putting forward plans to boost US employment that explicitly allow for inflation to run above the central bank’s 2.0-percent goal.
Minneapolis Fed President Narayana Kocherlakota says he could live with inflation of 2.25 percent, while John Williams of the San Francisco Fed says he can tolerate 2.5 percent.
The Chicago Fed’s Charles Evans, seen as one of the central bank’s most pro-growth “doves,” would keep interest rates low as long as the inflation outlook stayed below 3 percent.
US consumer prices for September are forecast to have risen 1.9 percent year on year, according to a Reuters poll.
While this is far from the double-digit inflation of the 1970s under the Fed chairmanships of Arthur Burns and William Miller, such views can hardly be comforting for central bankers in Asia sitting on truckloads of Treasuries.
Paul Volcker, the Fed Chairman who eventually put the inflation genie back in the bottle in the early 1980s, had a clear message when speaking before Congress on May 15, 2008.
“If we lose confidence in the ability and the willingness of the Fed to deal with inflationary pressures and sustain confidence in the dollar, we’ll be in trouble,” he said.
If Asian central banks conclude Volcker’s warning is coming true that could be very bad news for the value of the dollar.

— Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own.