Why Did Foreign Central Banks Dump $32 Billion Worth Of U.S. Treasuries Last Week?

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by: Avery Goodman

The most recent H4.1 balance sheet release from the Federal Reserve reveals an interesting event. In the past week, foreign central banks have liquidated slightly more than $32 billion worth of US Treasuries. That there has been a foreign central bank treasuries selloff is not news. A large amount of liquidation has been steadily going on for several weeks. This week, however, the size of sales might turn a few heads. Sales were more than four times the size of the week before.

Is this the ultimate liquidation so many "honest money" advocates have warned of for so many years? Without more hard data from the ever secretive Federal Reserve, it is impossible to determine with certainty what is actually driving it. Of course, if foreigners are doing these sales in order to dump the fiat "dollar" (a/k/a Federal Reserve Note), the Fed would do everything in its power to prevent anyone from getting that information. The last thing they'd want is everyone selling also. That would mean that the fiat money game is up, and the bottom would drop out of the stock and bond markets.

There are several possibilities. The "honest money" interpretation is that foreigners are finally waking up to an irredeemable fiat currency that is over-printed and are ridding themselves of it. Foreigners might be rejecting the so-called "Operation Twist", seeing it as just another debasement designed to prevent the bloated Fed balance sheet from ever being wound down. If so, when markets nervous about Europe calm down, the US currency would collapse quickly.

But this view gives a lot of credit to the intelligence of foreign central bankers. Most of them have been educated in the same institutions as their American comrades. They blindly believe in Keynesian economic theory like their developed world counterparts. It is unlikely that such people would take the blinders off in order to be confronted with reality. Foreign central bankers will be the last ones to sell treasuries, prior to the ultimate crash and burn of the dollar.

Another, more benign explanation, is that US treasury liquidation is designed to raise dollars for international banks, especially in Europe, who have trillions of dollar denominated debt obligations that need to be serviced. To supply necessary dollars, the ECB might be selling US treasuries, for example. Yet, this doesn't make a lot of sense. The US Federal Reserve has already agreed to supply an unlimited number of dollars to the ECB, Bank of Japan, Bank of England, and other central banks. There is no reason to engage in fire sales to raise dollars. The central banking world is flush with dollars.

Still another possibility is that emerging market central bankers are heavily selling treasuries. Nations such as Russia and Brazil were previously buying large numbers of treasuries in an effort to hold down quickly appreciating higher-interest bearing currencies. They could now be selling to slow a potentially destabilizing fall in those same currencies resulting from fear about an oncoming new crisis. This explanation fits best into the known proclivities of fiat money central bankers and the historical facts "on the ground".

We don't know the mix of what they are selling. We don't know if they are selling long term or short term treasuries. But we do know that the Federal Reserve is buying long term treasuries. Any rational person will prefer to sell long-term holdings to the Fed. Looking at this heavy selling, it seems quite likely that the FOMC saw it coming. Perhaps that is the reason they launched Operation Twist even though it had failed in years past. But this rate of selling is 4x the amount of long term treasuries the Fed has announced plans to buy, and cannot have been anticipated.

The selling is probably by emerging market central banks. They are probably using the dollars received to bolster falling emerging market currencies by buying them in exchange for dollars. They are probably opportunistically taking advantage of price support provided by the Fed's Operation Twist. This may be a temporary phenomenon, but it may cause the Fed's "Operation Twist" to be more of a failure than it was many years ago. At any rate, as long as the crisis in Europe continues, and it is likely to continue for at least several more months in one form or another, markets will remain nervous. The US dollar should remain artificially "strong" unless and until the Fed starts up the QE printing presses again.

People are going to discover that the events in Europe will not dramatically dampen world commodity demand, as they now believe. That should bolster emerging market currencies and slow down the treasury selling. However, this realization may take a few months. Heavy treasury liquidation, therefore, should continue. At this rate, long term bonds are probably being offered back to the Fed at a faster pace than its plans provide for. The remainder of the bonds will be sold to others. A sharp increase in the supply of long term bonds will cause higher long term interest rates, rather than lower ones. Higher long term rates will put downward pressure on stocks and real estate.

Funding should become more expensive, crimping corporate profits. Pressure will increase on the insolvent members of the developed world banking community, and loans will become more difficult to obtain. Real estate will slow down further, from America to Spain and beyond. The traditional indicators of economic health will surely deteriorate. None of this is necessarily a bad thing, in the abstract, except when viewed from the view of politicians who want to be reelected, and economists schooled in blinder-prone Keynesian economics. For adherents of the "Austrian" school of Von Mises and Hayek, long term problems arise out of the government's response to economic stress, rather than the stress itself.

Investors should not be misled by dollar strength. The Federal Reserve Note is no "safe haven", nor are the bonds which are its derivatives, as illustrated by the massive selloff now taking place. This is not a risk-on/risk-off scenario, as much of the media would like you to believe. Such assertions are patently ridiculous. The dollar is now a temporary beneficiary of money flows, as it was at various times in the past. That has nothing to do with investor sentiment toward "risk". American banks and money market funds simply don't want to lend to insolvent European financial institutions. That doesn't mean people like Federal Reserve Notes or trust Federal Reserve policies or the US government.

Once again, last week's treasury liquidation rate was 4x higher than the rate at which the Fed is buying bonds. That means it will negate all the Fed bond buying and then some. Given the proclivities of the Fed's FOMC, it also means QE3 is on the way sooner than most people think. Private investors should join emerging market central bankers in selling treasuries while good prices can still be gotten for them. Portfolio allocations to treasuries should be replaced by precious metals for the time being.

The PMs look like they have bottomed out. People familiar with the physical metals market say that very little to no physical metal was liquidated during the recent price drop. On the contrary, there was massive buying in the physical market. The price collapse was solely a function of the paper-traded derivatives. If precious metals prices stay at current low levels, for more than a few weeks, supplies will be so depleted that prices will be forced back up by the physical market.

Meanwhile, a careful eye should be trained upon equities markets. Stock prices have been artificially pumped up by a flood of liquidity. They are now going to come under pressure from macro forces. Even if more free funny money comes, QE3 will benefit mostly Fed-connected primary dealers and associated financial entities. Earnings in most non-financial industries, in contrast, will suffer. Strapped consumers, saddled with paying for the commodity price increases that a new round of QE will bring, will be on strike. This will doom earnings.

While stock prices are bolstered by funny-money, the process is subject to the law of diminishing returns, and the reality check of inflation. Fed-connected speculators will be rich in funny money cash, but won't have any place to use it effectively if equity earnings drop significantly. If they can no longer make "big money" from stock speculation, attention will inevitably shift to long positions in commodities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.