Tough Choice- Steady US Dollar or Lower Long-term Interest Rates?

On Wednesday, the Fed said it would pump more than USD1 trillion into the economy to help revive the housing market. The plan includes buying up to USD300 billion of long-term government bonds over the next six months. The immediate effect of the plan is a sharp drop in US Dollar (see Chart 1 below) & a sharp rally in long-term Treasury Notes (see Chart 2 for the performance of the 10-year Treasure Notes, TNX).


Chart 1: USD's daily chart as at March 19, 2009 (Source: Stockcharts.com)


Chart 2: TNX's daily chart as at March 19, 2009 (Source: Stockcharts.com)

The sharp drop in the US Dollar could lead to higher inflation further down the road. We can see from Chart 3 below that the Great Inflation of 1965-82 led to higher interest rates and coincided with the sub-par performance in the equity market. The US equity market begun to rise only after inflation had started to decline in early 1980s. The drop in inflation rates allowed the Fed to reduce interest rates steadily over the past 25 years. In the process, this had created one of the greatest boom in the history of the US stock market.


Chart 3: TNX & DJIA's weekly chart from 1963 to March 19, 2009 (Source: Yahoo Finance)