Central Banks Shift Reserves Away from U.S. Dollar

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Includes: UDN, UUP
by: Jeff Nielson

The problem with trying to specify why the U.S. dollar is currently having its worst collapse in two decades is that one would wear out their fingers on their keyboard before they ran out of reasons.

Let's start with economic fundamentals. The U.S. is hopelessly insolvent. It has over $57 trillion in current public/private debt (see “A Tale of Two Economies: U.S. versus China”). However, since none of the three levels of governments properly accounts for their future obligations, their largest liabilities are not even recorded on their balance sheets – with “unfunded liabilities” for the federal government (alone) somewhere around $70 trillion. With real GDP of roughly $11 trillion per year, this economy is simply much too small to even service those debts and liabilities. Given that there are no assets “backing” the U.S. dollar, then obviously the value of a currency of a totally insolvent economy is near-zero.

With mountains of debt far in excess of the rest of the world combined, allowing (or rather encouraging) the collapse of the U.S. dollar is the only way for the U.S. government to delay formal bankruptcy.

Most of the remaining arguments which guarantee a weak dollar in the future fall under the category of either “supply” or “demand”. On the supply-side, a recent article in The Telegraph puts one measurement of U.S. money-creation at over 100% for the previous year, with the even more insolvent financial system of the U.K. showing growth in the money supply of more than 160%, using the same measurement.

This is more than ten times higher than during the loose monetary policy which caused all these bubbles in financial markets. Like an alcoholic, who reaches for a 'bottle' first thing in the morning to relieve his hang-over, the U.S. and U.K. are doing much more of what caused their problems in the first place – and calling it a “fix” (again, much like an addict).

Meanwhile, a world already over-saturated with U.S. debt has been bombarded with trillions of dollars in new U.S. Treasuries. The “TIC reports” for this year show that instead of the usual $100+ billion per month in accumulation of U.S. debt by foreign entities that these same investors have dumped (on a net basis) hundreds of billions of dollars of U.S. “assets” this year (see “Foreign Investors FLEE From U.S. Debt”). In order to pretend that there is still demand for U.S. Treasuries, the U.S. has begun to “monetize” this debt – printing money to “buy” its own debts.

The Federal Reserve has engaged in massive chicanery to hide most of these purchases, aided by the Treasury Department, with its own reports on Treasuries auctions now so convoluted that traders with decades of experience in this market are totally unable to even decipher the descriptions of what is taking place in those auctions.

Ultimately, the key demonstration of demand for the U.S. dollar (or lack thereof) are the currency reserve ratios of foreign governments. Over the last several decades, the holdings of U.S. dollars have constituted well over 2/3rds of the holdings of foreign governments. However, in the 2nd quarter, foreign governments were only putting 1/3rd of their surpluses into U.S. dollars – literally only half of historical demand.

Exacerbating this trend, thanks to the Wall Street-engineered global recession, those surpluses are all much smaller than they were just two years ago. Thus, at a time when the U.S. has doubled its supply of U.S. dollars, demand has simultaneously been cut by more than half. Even those without a firm grasp of basic economics can understand what these parameters mean. And the recent collapse in the U.S. dollar would have even been worse, but several Asian central banks intervened in currency markets last week by buying up some dollars – perhaps the only thing preventing the dollar from a complete nose-dive.

As if these economic and supply/demand fundamentals weren't already bad enough, as many (including myself) have pointed out, the dollar has been selected by traders as the new “carry-trade” currency, inheriting the yen's dubious honour as the world's official “weakest currency”.

This new “role” for the dollar comes as the result of the combination of near-zero interest rates, along with an economy (and particularly, a financial sector) which is so weak that traders are convinced the U.S. government will be unable to raise interest rates at any time – again much like Japan, and its “lost generation” with the yen. The only way in which U.S. interest rates will rise is if higher rates are imposed on the U.S. by the global bond market. Since such a move would occur only based upon soaring U.S. inflation and/or a fear of imminent debt-default, even if rates were forced higher this would not cause increased demand (for the exact reasons why rates were forced up).

This carry-trade status ensures that the dollar will be even weaker in the future than it would have been on fundamentals alone, because the mechanics of the carry-trade dictate that vast quantities of the carry-trade currency are continually being dumped onto global currency markets.

If it seems that dollar-bears are taking excessive “pot-shots” at the dollar, it's because there remains a huge contingent of inane dollar perma-bulls. These “experts” don't let a little thing like the U.S.'s insolvency stop them from boldly predicting that the dollar's current collapse is only a temporary, short-term trend. However, when it comes to “reasoning”, the dollar bulls are capable of nothing more than pointing to past periods of dollar weakness – and mindlessly concluding that those outdated patterns will repeat.

The problem is that in previous currency cycles, the U.S. wasn't sitting with $57 trillion in existing debts, and an additional $70 trillion in unfunded liabilities. In past cycles the U.S. didn't have interest rates frozen at their lowest level in history. In past cycles there was not a clear move away from the dollar by the entire global community. And (of course), in past cycles the U.S. dollar was not a carry-trade currency.

Yes, truly, it is “different this time.” However, don't bother trying to convince dollar-bulls of this. They would much prefer living in the past.