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Bretton Woods II is collapsing. Amid increasing skepticism from China regarding the security of its holdings of U.S. Treasuries, the U.S. Federal Reserve’s FOMC announced on Wednesday that it would purchase $300 billion worth of U.S. Treasuries in the next six months – effectively monetizing its debt and firing up its printing presses. This announcement caused the U.S. Dollar (USD) to fall precipitously against the Euro, in addition to causing the price of Gold in USD terms to jump – demonstrating the market’s belief that the U.S. was well on its way to deflating its debt and debasing its currency.
Conventional wisdom holds that the Federal Reserve did this without much regard for its impact on the value of China’s holdings. However, given the buildup in negative statements by China’s leadership about the stability of U.S. Treasuries, a unilateral move by the Federal Reserve would be the diplomatic equivalent of giving China the middle finger. The U.S. is in no position to do that. If the Chinese government were to fear that the value of its holdings is going to decline, it would be obliged to sell them off and salvage whatever value it can before the market for U.S. Treasuries crashes. With more than $700 billion in U.S. Treasuries, China is the largest foreign holder of U.S. Treasuries, ahead of Japan, UK and the GCC countries.
That such a sell-off has not yet occurred indicates that the move by the Federal Reserve to monetize its own debt was carefully discussed with the Chinese government. Since the statement by the FOMC neglected to specify whether the purchase would be of fresh Treasuries, the possibility cannot be ruled out that the Federal Reserve intends to purchase Treasuries that have already been issued. And in that case there is the possibility that the Federal Reserve has promised to purchase a part of China’s holdings of U.S. Treasuries in return for assurances that China would not precipitate a premature destruction of the USD. This would not have as great and direct an inflationary impact as the Federal Reserve purchasing fresh U.S. Treasuries issued by the U.S. Department of the Treasury. However it does point to a highly disturbing and very likely possibility that the U.S. is about to severely debauch its own currency.
China has been the largest holder of U.S. Treasuries since September 2008 when its holdings ($618 bn) surpassed Japan’s ($617 bn). Since then China has grown its holdings to $739.6 bn (January 2009), up more than 50% since January 2008. The monthly growth rate in China’s holdings has, however, declined from its peak of 10.66% in November 2008 to just 1.68% in January 2009. The corresponding monthly growth rate for Japan’s holdings peaked in July 2008 at 8.2% and has since declined to 1.41% in January 2009. This has been accompanied by a steep decline in exports for both nations in the final quarter of 2008 and the first quarter of 2009. Simply put, these nations are no longer as flush with dollars (thanks to Himalayan exports) as they used to be. With their own economies in tailspin, both governments are more concerned at this moment with stimulating domestic demand for their own goods.
In this context, if the U.S. Federal Reserve is indeed going to purchase Treasuries that are currently held by China, it effectively implies that China will not be purchasing Treasuries in any significant numbers in the future. By some accounts the U.S. government is set to issue upwards of $2.5 trillion in fresh treasuries in 2009 in order to fund the various spending programs it has announced, an astounding 81% increase when compared to the total U.S. Treasuries held by foreign entities. Since 2002, more than 80% of the fresh treasuries issued by the U.S. Department of the Treasury have been purchased by foreign entities. Hence the slowdown in purchasing them by China and Japan (who collectively purchased more than 44% of the Treasuries issued since January 2008) is cause for serious concern.
It is fairly obvious that China and Japan, the two countries whose purchase of Treasuries has provided the most support for the USD, will be unable to continue at their historically high rates of Treasury uptake. This, coupled with the incredible increase in U.S. spending, should be enough to cause the USD to plunge like a rock. As if this isn’t enough, the possibility of the Federal Reserve purchasing U.S. Treasuries held by China, if true, means that Bretton Woods II is well and truly dead and the USD is heading that way faster than was first thought.
Stock position: None.
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This article has 28 comments:
The game plan is for these competitive pressures to allow the world to monetize its debt collectively, while maintaining the delicate trading relationships necessary to shore up employment.
This plan will unilaterally hurt creditors (e.g. China, wealthy folks) and help debtors (e.g. US Govt, consumers, home owners, etc.) So why will our creditors allow this to happen? Because they ultimately have an interest in preserving stability along with everyone else. It's not good enough that they have money -- they need to keep making money to survive.
And keep in mind, the folks with the money (creditors) are smart. They get it. Ultimately our creditors will act in their own best interests, which is not the death of the dollar.
Everything else is just a political show -- noise and posturing.
Like chess, this a game that requires you to look several moves ahead.
On Mar 22 11:15 AM David Sawyer wrote:
> I agree with you that the dollar will fall hard given
> that the action of buying our own debt expresses concern for our
> nation...
Calling the USD 'dead' sounds both permanent and alarmist ... but maybe it takes eye-cateching headlines to entice readers to open up a link.
Conventional wisdom holds that the Federal Reserve did this without much regard "for its impact on the value of China’s holdings." No, that would be a knee-jerk assumption, wouldn't it? 'Wisdom' would reason, as the author did, that "the move by the Federal Reserve to monetize its own debt was carefully discussed with the Chinese government."
The USD will very likely devalue, but as texaser correctly points out, " ... every nation on earth also wants to devalue" to support their trade exports. There's some relative value to be considered, as well as the underlying creditworthiness of the US.
And again texaser wisely says, "this a game that requires you to look several moves ahead." Amen. Let's not try to call the game over in the opening minutes.
In the race to the currency bottom, the US will ultimately preserve the USD's desirability by coordinating monetary moves, and by assuring creditors of its ability to weather the coming financial turmoil over months and years, rather than days or weeks.
During that longer period nations that can contain the resulting inflationary spirals will do well.
An alternative to another world reserve currency, or in addition, would be to introduce a competitive currency for our debased D.C. dollar.
Is the Fed just debasing the currency? Is it time for dual currencies here in America? Perhaps a Fed Reserve West in the heartland, with a N.A. dollar (North American dollar), with tight bank management controls, good IT team, and transparency and accountability, especially when temptation (creating money) is at the door or window. Start the 2 currencies at par. Then let all Americans decide what currency they prefer in transactions, both personal and for business accounting. A more limited supply increases the value of any commodity, including a currency; hence protecting the value of a currency. There is too much money out there idling already; more geenbacks by the Fed is not the solution; too much debt is the problem. Debt city or deleveraging city (D.C.) what's the call - America?
If the Fed were buying fresh Treasuries, that would be giving the finger to China because the actions (monetization of US Debt) would lead to a precipitous decline in the value of the dollar (and thus China's holdings).
In doing that the US risks sparking a Treasury war of sorts with China. China might decide to offload its holdings of Treasuries ASAP in order to harvest / salvage whatever value it can as the dollar heads to bottom.
I think that's too great a risk for the US Fed and Dept of Treasury to want to deal with right now. They've most certainly coordinated this with the Chinese and have worked out a deal.
On Mar 22 11:15 AM David Sawyer wrote:
> Shaunak, very nice work here... I wanted to ask you though in more
> detail why you believe the US is giving the proverbial middle finger
> to China if the purchase of the debt increases the value of the debt
> they own? I agree with you that the dollar will fall hard given
> that the action of buying our own debt expresses concern for our
> nation...
It seems to me that China is now more focused on trying to stimulate domestic demand and cornering resources around the world.
Furthermore, given the amount of fresh debt the US intends to issue this year ($2.5 trillion), it is very doubtful if there are enough nations out there with the trade surpluses to buy them up.
We would all like to see what you have mentioned. But that would take tremendous cooperation and a coinciding of interest all around the world. And even then the USD would surely devalue given the amount of spending planned.
Maybe there'll be a collective outbreak of groupthink and the international system will be saved to crash another day. I don't see it happening.
Cheers!
On Mar 22 11:38 AM @TexasER wrote:
> The US needs a week dollar and high inflation to resolve the debt
> crisis. China also needs a week Yuan to make its exports more competitive.
> And every nation on earth also wants to devalue.
>
> The game plan is for these competitive pressures to allow the world
> to monetize its debt collectively, while maintaining the delicate
> trading relationships necessary to shore up employment.
>
> This plan will unilaterally hurt creditors (e.g. China, wealthy
> folks) and help debtors (e.g. US Govt, consumers, home owners, etc.)
> So why will our creditors allow this to happen? Because they ultimately
> have an interest in preserving stability along with everyone else.
> It's not good enough that they have money -- they need to keep making
> money to survive.
>
> And keep in mind, the folks with the money (creditors) are smart.
> They get it. Ultimately our creditors will act in their own best
> interests, which is not the death of the dollar.
>
> Everything else is just a political show -- noise and posturing.
>
>
Cheers!
On Mar 22 04:49 PM waf76 wrote:
> @texaser - couldnt have said it any better myself. for China to
> sell off mass holdings of us treasury and to destroy the dollar would
> be the equivalent of declaring war.
"US Treasury bonds will remain central to China's plans for investing its massive foreign exchange holdings, a deputy governor of the Chinese central bank said Monday.
"Investing in US Treasury bonds is an important element in China's investment strategy and we will continue this practice," Hu Xiaolian told reporters."
Chinese media reported last week that the forex reserves had fallen by about 30 billion dollars in January, partially due to a drop in the value of non-dollar assets."
The huge (for Americans) savings rate of the moment means there's an extra $550B on the sidelines every month. That money could indeed stay in the States, buying up whatever Messrs. Obama and Geithner proffer.
On the other hand, not all nations are kindly disposed to us and someone, somewhere is bound to see this as their "moment." No matter what else happens, we could make up one day and hear that people want to be paid for oil in khaleejis, euros or something else. For Americans, that would send commodity prices skyrocketing in the short to medium term. Longer term that could sort itself out as it will force the uncapping of wells here which are currently not feasible to operate. We'd also find out if the conspiracy theorists are right about huge reserves in Alaska and the Dakotas.
The dollar will take a hit for a while until the next round of bad news out of the EU. Sit back, relax...and let it happen.
China has a 2 decade head start? They'll need to buy more bonds. Eitehr that or buy American dairy exports, cat food, untainted milk, Christmas ornaments, fishing poles, and cheap jeans. Naaa...it'll be bonds.
The G20 declared in principle not to engage in protectionism. While not technically protectionism, debasing one's currency certainly reeks of it.
Caught a glimpse of a report in Bloomberg China intends to keep buying US bonds. (Still need to confirm that...but I suspect it's right.) Look, when all this is said and done, those bonds will hold more value in the long term.
The dollar is not dead, it's just out in front...like a reserve currency and an administration bent on taming this crisis (rightly or wrongly) should be. The euro will follow in a few months, most likely.
The thing that is hurting the dollar in the past week and today is fear and risk appetite, respectively...
What are they going to buy Treasuries with if their trade surplus is wiped out thanks to a precipitous drop in exports (4Q08)?
A fall in imports has kept the trade surplus in the black, but given its position as an assembler more than a manufacturer (value added in China is less than 30% of the total value of the product), a fall in imports is bound to lead a fall in exports.
What then? China cannot print USDs ... only Ben can.
And I do not know the answer to your question. The bottom line is, this crisis is one giant, nasty sandwich we are all taking a bite from, China included.
It might be best if China just held treasuries in hopes of future relative strength against other instruments (despite the arguments for a burst treasury bubble which may or may not happen.) And maybe ease their purchases a bit and took it on the chin like the rest of us. But, even as yields fall, the US treasuries may still be the best thing going as other nations enter QE.
Good, interesting question.