US Treasury Dilemma Could Spur Dollar Gains For All the Wrong Reasons

Another opportunity is in store for the US to lure investors by boosting expectations and preparing for growth. Just as the European debt crises began in the first quarter of 2010, history is repeating itself in 2011. This time, with Portugal and Ireland. Despite some signs of life with strong manufacturing and employment wages, the ECB will not hike rates for a while, and instead focus on structural issues. With inflation on our back, the US Dollar has the potential to reverse on speculation...for all the wrong reasons.

The era of cheap money is over, right? Not quite. There are still many underlying problems in which rate hikes will flirt with systemic danger if continued. Pay close attention to treasuries. Notes have declined recently as traders begin to factor in inflation. Yields have risen on 10 year treasuries: 14 basis points (0.14 percentage point) to 3.58% from 3.44% in March.

The inverse relationship - drop in treasury prices and rising yields - was brought upon by lower demand for treasuries in recent auctions. Investors expect greater returns as higher interest rates begin to direct the flow of cash out of government safety and into various asset classes, hopefully lending. This type of activity usually provides a boost for the US Dollar as investors become optimistic, preparing for growth, but current conditions paint a different picture.

The Dollar has consistently dropped against other currencies. One obvious reason is inflation being the immediate concern in the Euro-zone and Britain. Second, is the spike in commodity prices. Oil is up to $113 per barrel and food prices continue to rise. This is not the right type of inflation that signals growth.

Commodity prices are volatile, and this is based on supply/demand and global imbalances. The chart above shows core CPI having a steady increase along a comfortable path, but when energy and food prices are added it looks troubling. This is because food and energy are volatile, and the sharp increase back to where we were before the recession seems painful. We've been too comfortable at the dip, but still ask for reasonable prices. Perhaps we can't fight supply and demand, or it could just be a volatility problem due to global conditions. Either way, the pain of paying for the stuff is a direct result of our currency's manipulation to calm the recession.

Money supply is a major factor that influences purchasing power. Fed measures such as quantitative easing increased the money supply which gradually reduced the value of the dollar. Today's prices seem more expensive because it has absorbed the amount of money in the system deemed to measure demand for the good. Not the case when it's been tempered with. Lower purchasing power plus what seems like higher prices, coupled with a global imbalance gives us excessive inflation.

US employment has picked up with manufacturing showing a strong recovery. This is a great start, but leaves out important fundamentals. The employment rate leaves out a lot of people, especially those who have dropped out of the labor force. Many Americans lack the skills demanded by employers after years of working in one sector without a diversified skill-set. Those who continue to get denied have either accepted lower paying jobs, or have enrolled in college or trade programs. These people are not counted in the unemployment statistic. The labor force is smaller, and the remaining individuals are the ones who are confident that their skills are up to par, weighed their options, and joined the working population.

Housing is still sluggish, and is not in the right position to be bothered with a rate hike. This will transfer interest on to mortgage holders - a main concern in the Euro-zone, which is why Trichet warned that the decision is not one to last.

Government debt is also a major issue. Investors are fleeing treasuries to hedge against further government misery. PIMCO recently dumped all treasury holdings, and even decided to place shorts on government debt. The Fed, the main buyer of US treasuries pushing down the yield and raising asset prices, is thinking of starting a monetary stimulus withdrawal. This will push treasury yields even higher and create an air of optimism. The hope is that investors are blind sighted into seeing this as real supply demand of capital. Price transparency is now questionable.

Bottom line for the dollar: CPI numbers at the end of this week will increase inflation chatter. At the same time the EU will release price data, but interest rates are exhausted now, so no expectations. Expect further Portugal mess and strong US data --  consumers can afford retail goods..it's part of core inflation after all.