Weak dollar poses risk to Treasury

A worker inspects U.S. dollar bills inside a money changer in Manila December 15, 2008.

NEW YORK (Reuters) - A U.S. dollar in decline, with short term interest rates sliding to zero, could end up destabilizing the fixed income and credit markets.

Now more than ever the United States needs a strong dollar to convince investors to buy new U.S. debt that will fund a massive fiscal stimulus package, and the banking system bailout, as well as two wars in Afghanistan and Iraq.

But the U.S. government may have to wake up to the reality that money will gradually move out of yieldless U.S. Treasury bills offering near zero return.

The Federal Reserve on Tuesday cut its federal funds target rate to range between zero and 0.25 percent, and three month U.S. Treasury bills are already offering a return close to zero, while longer dated U.S. Treasury bond yields are at 50 year lows.

"As an investor, you have to ask yourself whether you take on that bond exposure and the currency risk," said Bob Sinche, global head of interest rates and foreign exchange at Bank of America in New York.

Investors moving away from Treasuries could hurt the United States, he added, "because the government will have...record Treasury issuance" given the likely massive increase in government spending under the incoming administration of president-elect Obama.

The U.S. dollar on Wednesday plunged to its lowest in more than 13 years versus the yen and fell to a nearly three-month low against the euro.

The U.S. dollar had rallied to 10 week highs against the euro and other major currencies recently, with the exception of the Japanese yen, as the global financial crisis of 2008 resulted in de-leveraging and repatriation flows.

But the Fed's rate cuts and moves toward quantitative easing of monetary policy this week sent the dollar sliding again.

"The question is whether investors will continue to take on Treasuries if the dollar is under pressure," Sinche said.

The situation is not the same as in Japan in the 1990s when that country suffered a long bout of low economic growth and deflation, analysts said. Despite Japan's low yields, the government was able then to finance a surge in bond issuance because of the country's huge domestic savings and local investors's willingness fund new government debt.

That's not the case in the United States, a country that is prone to spend than save. Foreign investors already hold more than half of tradable Treasuries and may not keep buying at Japan-like yields with the U.S. dollar at multi-year lows.

CREDIT MARKETS RISKS

The credit market is also at risk with corporate bonds and home mortgage rates already trading at historically high spreads over U.S. Treasuries.

"While Treasury rates are falling, key private sector rates are not," said Richard Bove, an analyst at Ladenburg Thalmann and Co.

"By cutting the fed funds rate to market levels, the Fed is not cutting rates for the private sector, where easing is needed, in part, because the dollar is falling in value. This may be part of the liquidity trap whereby whatever the Fed does has no impact on the economy."

Bove urged the world's finance ministers to undertake coordinated action to stabilize currency values.

Analysts have also cited the risk of a zero-yielding dollar becoming a funding currency in carry trades, making it a perennially weak unit in the foreign exchange world.

Low interest rate currencies, such as the yen, tend to come under heavy selling pressure as investors borrow cheaply in the Japanese unit, then sell the proceeds and invest in higher yielding investments in other currencies.

Short term U.S. dollar interest rates are now lower than Japan's.

Michael Woolfolk, senior currency strategist at Bank of New York-Mellon in New York, said the carry trade is the least of the dollar's worries at the moment.

That's because the conditions that make carry trades work, such as low market volatility and a destination country with high interest rates and robust growth, are absent.

The yen-funded carry trade that has been violently unwinding this year had many attractive assets to target, including emerging market assets and currencies of commodity-rich developed countries such as Australia and New Zealand.

Now, central banks in Australia and New Zealand are slashing interest rates, sending their currencies lower and investors fleeing from emerging markets of all stripes.

That, however, could change in the second half of 2009.

"If volatility returns to normal and the dollar has low rates compared to other major currencies, then yes, I think that could begin to weigh against it," Woolfolk said.

For now though, analysts say the dollar has more pressing concerns.

(Additional reporting by Steven C. Johnson;)