Bernanke's balancing act must go on

Ground Floor:  President George W Bush's popularity isn't the only thing that's falling lately. The dollar has been in decline for some time too. It recently hit an eight-month low against the Japanese yen while breaking through the eight yuan barrier for the first time since the revaluation, propelling it into headline territory again.

Despite arguments that they favour a strong currency, most commentators believe that the dollar will fall further because the US administration is quietly supportive of seeing the greenback decline. A lower dollar is welcome in helping to make US exports more competitive and dent the US trade deficit which lingers around $725 billion (€565.4 billion).

Although a lower dollar should ultimately help the trade deficit, another factor is the impact it is having on bond and equity markets. The yield on the US benchmark 10-year bond is at its highest in nearly four years at 5.2 per cent.

Since yields go up when prices go down, that means that people who bought treasuries some time ago bought them at higher prices and lower yields and are, therefore, losing money. However, many of the buyers of US treasuries are overseas investors, particularly Asian investors. So they are now holding bonds which are yielding less than when they bought them as well as facing a currency loss.

The US administration won't want its bond holders suddenly getting scared into thinking that they're on a hiding to nothing here, because they desperately need all those overseas holders of treasuries (who are effectively lending money to the government) and will want to manage any dollar decline as well as treasury slide.

US interest rates have been continuously rising and have, to some extent, supported the dollar. With inflation concerns picking up, the Fed continues to monitor rates carefully and has recently seemed to change its stance on well-signalled market moves, leaving participants guessing as to whether or not they will increase rates again in June.

Currently, the view is that two years of regular increases is enough. But not everyone is certain about that. Ben Bernanke, just a few months into his role as Fed chairman, is facing a tough task with conflicting economic signals. He is looking at inflationary pressures as a result of higher energy and commodity prices which would indicate that rates should be higher. At at the same time, however, he may see the potential for a fall-off in consumer demand which could impact on economic growth and which could actually lead to rates being lower.

The gap between the yield on inflation-protected bonds and normal treasury bonds is at its widest in a year, which means that investors themselves are taking a glum view on US inflationary prospects.

Following its last rate hike, the Fed's open market committee appeared fairly sanguine about the inflationary outlook, although it did point out that higher costs thanks to surging energy prices posed potential inflationary pressures.

Bernanke told congress that the Fed might have to assess the situation further and might pause in its rate hike programme while it took stock of economic conditions.

Then he pointed out that a pause wouldn't necessary mean that they would stop raising rates altogether. The core inflation rate - which excludes food and energy - is at 2 per cent, which is actually the top of the Fed's target range. That would signal a further increase.

The economy is still growing, which would also signal an increase. However, job creation is weaker than expected and the housing market is in decline. Another increase might be one too many. So the new guy on the block has to engage in a balancing act in order not to tip the economy too far in one direction or the other.

Bernanke's balancing act will have an affect on the global economy. Global equity markets are having a fit of nerves as investors wonder whether or not rising interest rates will choke the economic growth that underpins corporate profitability and higher share prices.

The potential for consumer confidence to finally crack is also a concern. In May, the US index dropped to 79.0 from 87.4 in April, much lower than the original forecasts of 86.1. Expectations on both house prices and oil prices are pessimistic.

This fall in consumer confidence only increases the push in sending equity, bond prices and the dollar lower. And, of course, allowing a currency to drift is in itself fraught since you can't exactly manage the rate of the decline. What starts out as a gentle drift can turn into an almighty fall before you realise it. And the next thing is that your carefully plotted strategy is in tatters and at the mercy of the world's feeding-frenzy traders.

Right now, the market is focusing on the next Fed meeting on June 28th and 29th. Market participants, still checking Bernanke's statements for nuances that would give them the edge, are evenly divided on the prospects.

Traders are jittery about the outcome as the up-and-down market moves of the last few days have shown. There's a general shifting of sentiment and everyone knows that, in the short-term at any rate, sentiment can be a much more powerful force on markets than rational thought ever could be.

Rationally, however, the dollar should be lower and US interest rates probably need to be higher. Managing that without scaring off the investors will be Bernanke's biggest challenge.

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