What’s next for the U.S. Dollar? QE3?

The dismal U.S. jobs report for May, released last Friday, caused the price of gold to soar as the market appears to be pricing in an ever-greater chance of “QE3” – another round of quantitative easing by the Federal Reserve (Fed). But given that 10-year government debt is already down at 1.5%, the Fed may dive deeper into its toolbox in an effort to jumpstart the economy. Investors may want to consider taking advantage of the recent U.S. dollar rally to diversify out of the greenback ahead of QE3.
To a modern central banker, it may be very simple: if the economy does not steam ahead, sprinkle some money on the problem. The Fed has done its sprinkling; indeed, the Fed has employed what one may consider a fire hose. But after QE1 and QE2, we continue to have lackluster economic growth, unable to substantially boost employment. Never mind that the real problem the global monetary system is facing is that the free market has been taken out of the pricing of risk:

• When the Fed buys government securities, such securities are – by definition - intentionally overpriced. Historically, when a central bank buys government bonds, the currency tends to weaken, as investors look abroad for less manipulated returns.
• Policy makers increasingly manage asset prices, be that by pushing up equity prices through quantitative easing; artificially lowering the cost of borrowing of peripheral Eurozone countries; or by keeping ailing banks afloat.

Investors increasingly chase the next perceived move of policy makers, thus fostering capital misallocation. Policy makers in Spain may not like paying above 6% for their longer-term debt, but lowering such rates ought to be the result of prudent policies, not because of a game of chicken between the Spanish prime minister and other European policy makers (if we only knew who the other chickens were – they are all hiding!). Similarly, U.S. growth is lagging because – let’s just name a few of the root causes - of ongoing global de-leveraging; the de-leveraging of U.S. households; uncertainty over U.S. regulatory policy; uncertainty over U.S. fiscal policy.

Read more: http://www.merkfunds.com/merk-perspective/insights/2012-06-06.html