In case you missed it, there was a “supposed leak” from the Fed this week. The Fed-Heads are saying they want to drain off the record amount of cash.

It’s worth paying attention to statements like this.

This past Monday, the Fed announced they’re working with market participants to figure out how to reverse repurchase agreements. The goal? To help drain the record amounts of cash the Fed has pumped into the financial system over the last two years.

Reversing repurchasing agreements is one way the Fed could sop up some of the excess cash floating around out there in the U.S. financial system…or I should say suck up the cash stuck at the banks where bankers still refuse to lend!

The Fed knows they’ve got a ton of excess money to suck out of the system. Otherwise, they risk a possible inflation or hyperinflation. This is why they are considering expanding past the 18 dealers, the “usual suspects” they’ve traded with in the past.

Translation: “Guys, we’ll need all the help we can get to reign in this ton of cash. Any takers?”

You see, the Fed has purchased $1.36 trillion in mortgage debt, government-housing debt and Treasury debt through Oct. 13th in their battle against deflation and the threat of a depression.

Forex traders are already looking at this as a great sign the economy, but that’s premature at best. Here’s why…

None of This Will Happen Overnight…If It Happens At All

Many traders are misinterpreting this. They believe this will all happen overnight. As such, traders are already making plans about how to trade as the Fed starts sponging up the excess liquidity. But none this will happen that fast.

In fact, the economists still don’t expect them to drain off the excess capital until LATE 2010. So traders are jumping the gun here.

Traders are also taking this as a sign that the Fed is going to raise interest rates soon. Get real guys! I think anyone who believes the Fed will raise rates anytime soon has completely missed the boat.

You raise rates to fight inflation. Right now the year-over-year inflation rate is -1.50% in the United States. In other words we have negative inflation or deflation still. No need to raise rates when we haven’t even “cracked” zero and gotten a little bit of inflation yet.

Oh sure, Australia has raised rates but it’s got +1.50% inflation vs. our -1.50% inflation. Big difference! Just because Australia has raised rates does NOT mean we’ll be doing the same soon here in the U.S.

As my colleagues have pointed out here in FX University Daily, Australia is in a totally different boat than us in the U.S. (financially speaking).

“Paying the Banks?” Good Idea But No Follow-Through

Bernanke is also still toying with the idea of paying the banks interest on their excess reserves. This is where I take him to task, big time!

The reason the consumer hasn’t picked up the baton and started spending again is because American consumers can’t get their hands on the cash they need for “big ticket” items like houses, cars, furniture, etc.

The banks are tight-fisted right now. How do you change that? Do what one central bank did and start actually CHARGING these banks interest on their excess reserves.

If you do this, you’ll find that they’ll make loans and get that money out the door very quickly. They are in the business of “compound interest.” But all banks are actually businesses, so bankers want interest working for them and not against them. If the Fed decides to charge them interest on unused funds, banks will start making loans….and quickly!

So in theory the idea could work, but the Fed hasn’t officially made their decision about what they will do from here.

However, just by the fact that the Fed is leaking information to the market about “test runs” of sponging up liquidity, shows they are toying with the idea of draining excess cash out of the system in the months to come.

Although, it’s worth nothing that no Federal Reserve has EVER managed to drain liquidity out of the system fast enough to prevent inflation.

Choose the Strong Country, Not the
“May Be Strong Again Sometime U.S.”

The bottom line: Since Australia has raised interest rates and others like New Zealand may not be that far behind them…money will continue to flow towards these countries and away from the U.S.

After all, what’s the incentive to buy dollars and hope the Fed will raise interest rates, when you can be in a currency that IS raising rates presently?

Also, the Reserve Bank of Australia has already talked very seriously about diligently hiking further in the future. So why bother holding money ran by the Fed?

Clearly Australia has embarked upon a new rate hike cycle and the U.S. has not. So I would be buying Aussie dollars, rather its lesser U.S. counterparts.

Till next week, have a wonderful weekend!
Sean Hyman

P.S. As I mentioned, I’m not overly impressed with how the Fed has handled this situation so far. It’s very possible these latest plans to drain liquidity out of the markets could just make this entire situation worse – especially if they actually do stop buying the Treasuries that no one seems to want. In fact, it could just add to what’s already being called the greatest asset bubble of our time.