Government Shutdown Threatens U.S. Dollar World Reserve Currency Status

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 |  Includes: GLD, UDN, UUP
by: Michael Fitzsimmons

While the dysfunctional US government is playing a deadly game of cat-n-mouse, it threatens to kill the golden goose: the US dollar's role as the global reserve currency of choice. Without reserve currency status, the US will not have be able to continue financing its massive debt at low interest rates. All this should be very bearish for the US dollar and very bullish for gold and silver. The longer the crisis moves closer to October 17th, odds are gold will take a step-function pop higher.

The chart below, taken from a recent article by the Pew Research Center, show the recent history of debt ceiling increases in relation to total public debt.

click to enlarge)Click to enlarge

Yet in spite of the massive run-up in the US national debt over the past two administrations, America has continued to enjoy the privilege of printing the world's reserve currency. Uncle Sam has been financing its national debt very cheaply.

Although the US is not likely to use this advantage anytime soon, anything that undermines the creditworthiness of the US government, as the current shutdown is obviously doing, is raising the risk of other nations accelerating their efforts to reduce exposure to US debt. The effect of a US default on global financial markets are unpredictable, but I am sure you would agree with me that it would not be a positive event.

The financial press is already reporting a rise in the price of US debt default insurance. CNBC reports the cost of insuring one-year U.S. government bonds against default rose 5 basis points to 35 basis points on Wednesday, above the rate of insuring five-year debt. Short term insurance rising above long term insurance (a curve inversion) is considered to be a sign of credit stress. Investors are concerned about the US government's ability to raise the debt limit in coming weeks and the risk that a U.S. default would lead to unstable global markets.

It would appear the Republicans are setting a precedent that, if successful, would make governing impossible for the foreseeable future. If a party with a small majority can shut the government down unless the other side repeals a law it does not like, it seems as though any legislation could be up for repeal by the minority. This would lead to paralysis, uncertainty, and volatile markets. It is certainly no way to run a country.

Gold Price in US Dollars Chart

Gold Price in US Dollars data by YCharts

All this should be very bullish for gold and silver bullion. Yet gold has not rallied and I cannot tell you why. The weakness in gold has been blamed on the prospect of Fed "tapering". Considering the Fed is currently printing over $80 billion a month as part of its "QE" program, a "small" $10-20 billion slowdown in the rate of printing money doesn't mean there isn't still a lot of printing going on. Nor does it mean there has been any meaningful change in trajectory of the national debt graph shown above.

As a result, there has been more talk than ever about an alternative to the US dollar. In a recent Forbes article, Jim Rickards, author of the best selling book Currency Wars: The Making of the Next Global Crisis, says the end result will be a move toward a basket of currencies, referred to as the Special Drawing Rate (NYSE:SDR), to be the next global reserve currency. Rickards says:

Everybody knows that the U.S. dollar's days are numbered but there is really no currency to take its place except for the SDR. What the world is trying to do is move to the SDR and China is fine with that.

The article references IMF records to report China's central bank has 1,054 metric tons of gold - a gold reserve China has not updated since 2009. Rickards believes China continues to buy gold. He said China has a pattern of announcing gold reserves every 6 years:

Prior to 2009 the last time they announced [their reserves] was in 2003, so this is nothing new. If you extrapolate that tempo, what you would expect is their next announcement maybe late 2014 early 2015. I don't know the number, but my first approximation would be between 4,000 5,000 [metric tons].

In addition to reserve diversification, China is buying gold because of their large exposure to US debt. Likewise, most Americans are 100% exposed to the US dollar and/or US debt, so why shouldn't they be buying gold too? It's a mystery to me. But gold moves very quickly, and I expect continued US government dysfunction will accelerate the move to a global currency SDR (could that be their unstated goal for acting so irresponsibly?). Gold would likely be part of the SDR basket. As such, American investors would be prudent to do like the Chinese and increase their exposure to gold. One can do it with paper gold like the gold ETF (NYSEARCA:GLD) or buy bullion at websites like APMEX.com or Kitco.com. When the light bulb goes off, gold will move very quickly higher. Now is a great time to take advantage of recent gold weakness as a result of over-optimistic expectations any Fed tapering might have on fundamental long-term US debt projections as a result of a dysfunctional government.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long gold and silver.