Dollar Strength: An Illusion

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 |  Includes: UDN, UUP
by: Edward Harrison

I have felt for some time that dollar strength is a counter-trend that has a sell-by date written all over it. The Federal Reserve is ballooning its balance sheet like nobody's business as it tries to be the global lender of last resort. This is very inflationary. Apparently, the Fed wants to trash the Dollar. And, despite recent events, I believe it will eventually get its wish.

The United States is the world's biggest debtor nation, dependent upon foreign governments to buy treasury and agency debt in order to maintain itself. However, two articles I read Friday have convinced me that this situation is about to change in a nasty way and Asian countries are about to let the dollar go (very big hat tip, Scott).

The first article concerns Taiwan and their apparent desire to stop buying agency debt for fear of throwing good money after bad.

From Barron's:

Taiwan's financial regulators reportedly have ordered that nation's insurance companies to pare their holdings of the debt and mortgage-backed securities of Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae securities, according to a report on the Internet site of Asian Investor magazine.

Such an order would be a stunning rebuke to Washington, coming a little more than a month after the federal government effectively nationalized the mortgage giants. Fannie and Freddie last month were placed into conservatorships with the Treasury standing ready to inject up to $100 billion through purchases of preferred shares in the government sponsored enterprises.

As a result, Fannie and Freddie debt has the "effective guarantee" of the U.S. government, a spokeswoman for the Federal Housing Finance agency, the regulator for the GSEs, said Thursday. (That was a "clarification" of FHFA director James Lockhart's earlier declaration to the Senate Finance Committee that Fannie and Freddie debt had the "explicit" guarantee of the U.S. Treasury, Dow Jones Newswires reports.)

Moreover, Ginnie Mae securities have always been backed with the same full faith and credit guarantee as the U.S. Treasury.

In either case, the Taiwanese action is a blow to the reeling U.S. mortgage market, which has been supported by the Republic of China's purchases of agency securities. According to U.S. Treasury data, Taiwan owned a very substantial $55 billion of U.S. agencies along with $43 billion of Treasuries as of June 30, 2007, the most recent date for which these data are available.

This certainly is bad news for U.S. interest rates, mortgage rates and the U.S. Dollar. However, more worrying s that mainland China seems to be following its Taiwanese brothers in rejecting the U.S.

From Reuters:

The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place, a leading Chinese state newspaper said on Friday.

The front-page commentary in the overseas edition of the People's Daily said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies.

A meeting between Asian and European leaders, starting on Friday in Beijing, presented the perfect opportunity to begin building a new international financial order, the newspaper said.

The People's Daily is the official newspaper of China's ruling Communist Party. The Chinese-language overseas edition is a small circulation offshoot of the main paper.

Its pronouncements do not necessarily directly voice leadership views. But the commentary, as well as recent comments, amount to a growing chorus of Chinese disdain for Washington's economic policies and global financial dominance in the wake of the credit crisis.

China is the largest holder of U.S. government and agency debt. If they go on strike, the consequences for the U.S. would be catastrophic.

It is hard to believe we are asking this, but events are pointing in an ominous direction: Is the U.S. government even solvent?

Disclosure: none