Currency markets are primarily driven by interest rates.  When rates in-country go up, a country’s currency usually will go up in tandem as investors will see a higher return for being long the instrument.  When rates go down, vice versa.  Since interest rates move inversely to bond prices, it seems a country’s currency market is uniquely tied to its bond market.  


This is where Fed policy comes in.  Everyone knows the Fed sets short term rates as does any central bank, and changes, or perceptions of coming changes in this level, definitely move markets.  The Fed has been actively involved in the middle and long end of the curve for some time now with its bond buying program or quantitative easing.  This has allowed the bank to keep interest rates low across the curve and allowed the U.S. government to pay basically nothing for borrowing almost twenty trillion dollars.  But what about when the Fed loses control of the bond market and the interest rate curve?  This scenario can also move markets, sometimes violently.  


Former Treasury Secretary Lawrence Summers recently said, “I thought regulatory authorities made a mistake when they looked at each institution, and said, ‘You’ll be safer if you withdraw from the markets a bit,’ and then forget that if all institutions withdraw from the markets a bit, the markets would be less liquid. The markets themselves would be less safe. That would, in the end, hurt all institutions.  I think there is a real issue there. Frankly, a lot of the effort that’s going into macro prudential should be into making sure we have liquidity.”


In other words, the Dodd-Frank bill which was an attempt to further regulate markets after the financial crisis of 2008, could have severely negative effects on treasury market liquidity if the Fed starts to raise.  If an institutional investor is long bonds, and those bond start to drop in price as the Fed moves, they may want to sell or liquidate large positions.  If the liquidity is not there, you could see violent, large swings in prices as traders try to find the other side.  


JP Morgan Chase CEO, Jamie Dimon is also concerned about bond market liquidity.  In April of this year, he said, “In a crisis, everyone rushes into Treasuries to protect themselves.  This will be even more true in the next crisis. But it seems to us that there is a greatly reduced supply of Treasuries to go around.  In effect, there may be a shortage of all forms of good collateral.  (Treasury) inventories are lower — not because of one new rule but because of the multiple new rules that affect market-making, including far higher capital and liquidity requirements and the pending implementation of the Volcker Rule,”


The resulting consequences to currency markets with extreme bond market swings are obvious.  The dollar could see large price moves and cause damage to investor portfolios.  Currencies and economies tied or pegged to the dollar would see widespread damage as well.  This will be especially true in emerging markets such as China and Hong Kong.  We’ve seen what equity market volatility did to the dollar and other global instruments over the past several months.  Currency investors should take these concerns into account when choosing where to place cash over the next year as it could be a wild ride.  Fed policy consequences are real. 

L Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience.  He is also an author of historical fiction thriller novels.  His first of several books, Currency, deals with the consequences of overwhelming sovereign debt.  He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV.