Comment: Would Cancellation of Fed Held Debt Weaken the Dollar?

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Would Cancellation of Fed Held Debt Weaken the Dollar?

I have heard bond traders echo this sentiment, but I have to disagree.

If the fed cancels out Treasury debt purchased in the QE operations, some market participants wonder how the fed will ever be able to drain the $1.5 trillion in excess reserves on account at the fed if, as and when they finally get around to raising interest rates.

When the fed buys Treasuries and mortgage backed securities it pays for them with freshly created reserves. Problem is that with the economy and loan demand still weak, the banks cannot put these reserves to work so they simply come back to the fed as EXCESS RESERVES earning an overnight interest rate of 0.25%.

The fed already has the Term Deposit Facility in place to extend the duration in these reserves to 28 days and longer if necessary. Moreover, the fed won’t need to reverse repo Treasuries (flip side of draining reserves) from it’s balance sheet because all it has to do is raise the interest rate it pays on these excess reserves.

Nevertheless, perception is often reality and if enough market participants believe that fed canceling of government debt is inflationary they will act accordingly and sell dollars, sell bonds, buy equities, credit and commodities. In other words they will go for the “RISK ON” trade.

However, if all the central banks were to undertake a coordinated debt cancelation, the effect on the foreign exchange markets conceptually could be a wash. But what about gold? If the price of gold gallops higher while FOREX rates remain more or less in a holding pattern, it suggests that the market believes that all currencies are being devalued against gold.

Therefore, government debt cancellation which could be seen as a form of fiscal stimulus may have to go hand in hand an increase in the rate paid on excess reserves. In other words expansive fiscal policy along with tighter monetary policy.

Ed Rombach