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.