Since the March lows, we have seen the Fed do incredible things never seen before.
It started with conventional things (like slashing rates and providing liquidity to markets) and quickly spiraled into modern day money printing via debt monetization and, even more drastically, buying corporate junk bonds.
This all quickly added up and Fed is on pace to spend/monetize around $8-10T this year. The effect of all the new money and credit in the system created the low in markets as traders realized the Fed put is stronger than ever.
So, everything is back on track… right?
In the short term, yes. The effect of what the Fed did reversed the selling in risk assets and actually has created a short-term bubble nature to markets worldwide.
Where could it go wrong? How could the Fed fail as the man behind the curtains, pulling the levers?
The answer, I believe, is the U.S. Dollar.
For the Fed to win, the dollar must die.
Why? Because a strong dollar undermines everything the Fed has and will do.
The Fed desperately needs inflationary forces to kick in so that it can achieve a few goals:
1. Lower the value of the dollar relative to other currencies
2. Inflation to inflate away the debt over time
The Fed would like to lower the value of the dollar because if the dollar kept getting stronger, every other country, especially emerging markets, would have a very difficult time as their respective currencies weakened against the greenback.
A lower dollar is the Fed’s international gift to emerging markets. Just to keep it simple.
The Fed wants inflation because without inflation over time, the cost to carry all the debt the Fed has created will remain high. The debt will never be repaid, but if the dollar were to weaken then it could be repaid with less valuable dollars in the future. This is what the Fed wants and needs given the amount of debt in the system… an inflationary push so that previous debt can be repaid with less valuable dollars.
The counter force to the Fed’s aim at creating inflation is reality.
The reality of the situation is that most of the world’s debt is denominated in dollars.
As such, anytime there is a shock to the system and there is less loan growth and more people repay existing debt, that creates a deflationary effect as less loan growth and more debt repaid is less credit in the system.
We saw this with the beginning of Covid, an international rush into dollars as those dollars were needed to repay existing debts of all kinds.
This is what the Fed needs to avoid, deflationary shocks, on its path towards stabilizing the economy.
In trying to achieve these ends, the enemy of the Fed is now the U.S. Dollar and I expect them to continue to do everything in their power to press it lower.
The question is whether the Fed or deflationary reality will win.
In the short term, Fed liquidity overwhelms rational thought.
In the long term, it’s anyone’s game.