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Wednesday, March 18, 2009

Fed's action sharply drove down dollar

Fed's new purchasing plan of over $1 trillion mortgage-back securities and long-term treasuries makes investors fret about the prospect of dollar. US dollar was driven down sharply today, the 3rd largest decline in recent history.

Dollardeclines1

(graph courtesy of Bespoke Investments)


And gold was up sharply, for almost $50:





WSJ reacts to the Fed's decision:

The problem with desperate measures: They can end up stoking fear, not confidence.

That's the main risk with Federal Reserve's shock and awe tactic of buying $300 billion in longer-term Treasurys and up to $1.25 trillion of mortgage-backed securities issued Fannie Mae and Freddie Mac.

The 10-year Treasury jumped, causing the yield to fall almost half a percentage point to 2.53%. But two key fear indicators immediately flashed red: Gold soared 6%, and the dollar weakened.

It's highly unusual for a central bank to print money to buy large amounts of financial assets. Such unorthodoxy succeeds only if its purchases are temporary -- and sufficient to kick start credit markets and the economy.

Any sign their impact is fleeting would raise expectations of further buying. If the Fed responds and balloons its balance sheet further, inflation fears intensify, hurting the dollar and pushing gold even higher.

The Fed's $300 billion would account for around 28% of government issuance in the next six months according to Barclays Capital. To keep yields low beyond that might mean even heavier spending. The Fed's decision Wednesday to ratchet up the purchase of mortgage-backed securities underscores its willingness to keep spending.

Investors should track the relationship between the dollar and Treasury yields. Ultra-loose monetary policy can debase the currency. That means foreigners, with around half of all outstanding Treasurys, could demand higher returns.

Yields are now artificially low because of Fed's proposed intervention. That might push investors into riskier assets -- something the Fed wants. It could also scare foreign investors, who are needed to fund the ballooning fiscal deficit.