Most domestic US investors do not understand the perception world economies have about The United States. Central governments around the world find themselves dependent on the decisions of the Federal Reserve and policy makers to govern the monetary and fiscal policies of the United States and the World. They have accepted this relationship because historically the United States has proven to be an economy with reserve and resiliency. Now, the perception of the global economy is changing rapidly, and that is dangerous.
As this relates specifically to the value of the US dollar, foreign governments are compelled to buy treasury bonds (NYSE: TLT) and sell their own currency and an effort to stabilize their export markets. During a time when the United States is positioning China as a currency manipulator through media sources within the United States, the rest of the world sees it a different way. The global economy considers the United States a currency manipulator, they are witness to higher prices, and they are not happy about the relationship because the United States is losing its position of prominence as a global economic leader at the same time.
Arguments can be made suggesting that the perception will change once the economy gets better. That may be true. My argument is that the economy will not get better for a handful of years, and that opens a large gap for change. Instead, it will remain fragile, and slight bumps in the road will cause significant risks in the market and economy.
More importantly, the global economy is concerned at a time when a recovery has already happened. The United States government is issuing debt at a rate twice that of the growth rate of GDP. Real debt levels even if Social Security and Medicare are discounted from the equation, exceed GDP already. With Social Security and Medicare, if the government intends on keeping its promises, national debt in the United States is four to five times GDP.
With interest rates at zero, the Federal Reserve has engaged in policy where it issues and then buys its own debt during the same month. A revolving cycle of debt issuance is nothing more than a ponzi scheme as the government tries to increase the velocity of money, inflation, and shrinking corporate margins. In the process, the value of the dollar has been declining precipitously. If that happens, central banks in the global economy are being pushed against a wall.
Foreign central banks are being forced to invest in a US dollar that is losing value. They are also being forced to do so at a level of interest rates that cannot go much lower. Therefore, investors in US debt at current levels are not investing because they find value in the asset, but instead because they have to. Foreign governments are the biggest holders of US treasury debt, they are the biggest buyers of US treasury debt, and they are the ones becoming more and more dissatisfied by the monetary policy the US government has allowed.
My argument has been that the day will come when foreign governments demand a higher interest rate for their money. When that time comes, the federal government will need to pay much more in interest for the revolving debt than it does today. This can happen even if interest rates stay at zero. In fact, if the Federal Reserve was not buying debt at such extreme levels, real interest rates would already be much higher than they are today.
The federal reserve and the asset purchase programs they have already been engaged in, including the new effort, which is largely just a continuation of what has already been happening, have artificially manipulated the price of treasury bonds and caused tension in the world. Soon, that tension will bring with it repercussions that could cripple the US economy.
Given the pressure that the United States is levying on China (NYSE: FXI), for example, I could imagine China deciding to sell all of their treasury bonds and engage in an independent economic movement focused on the rest of the global economy. Selling bonds is not a bad idea anyway, from an investment standpoint, because the prices are artificially inflated, and even Bill Gross knows that will change. From an investment standpoint, China may find it prudent to sell into strength, like other institutional investors do. This is a far-reaching supposition, but something I know to be true is that given a choice the Chinese would rather buy from themselves than buy from the United States. My travels have taught me that, my observations corroborate it, and the nature of the communist regime in China proves that they are capable.
Reasonably, and not far-fetched, the Chinese could abruptly decide to discontinue the policies they have been using to support the US dollar. In fact, the global economy could do so in unison given their discontent. Maybe then the United States would revisit prudent fiscal and monetary policies.
Unfortunately, most people do not act in advance of adverse situation. In 2007, for example, investors should have sold all of their longer-term assets. Instead, most of them sold at the beginning of 2009. The same thing is true for our government. The United States should have been engaging in prudent fiscal and monetary policies for the past 20 years, but instead it will wait until it is forced to take action, but by that time it may be too late. The value of US treasury bonds is artificial, and I believe foreign governments will soon stop buying US debt. They are being forced to do so now, but I do not think they continue to do so for long.
The moment information pertaining to this subject begins to leak, the rally in US treasury bonds will come to an abrupt end. Unless prudent fiscal and monetary policy is adopted immediately, the Treasury will be the only ones willing to buy US government debt after awhile. Interest rates will need to go up to attract investors, and even if the target rate remains at zero the federal government will need to pay substantially higher interest payments than it does today. Given the massive amount of debt the United States is currently holding, even a slight 50 or 100 basis point increase in rates could cripple the economy even further by depressing Treasury Prices (NYSE: TBT).
Eventually, spending cuts will be proposed on Capitol Hill, clearly they will not compare to the monetary stimulus that has already been defined as uncertain and uncharted waters, but if the interest on the revolving debt increases at the same time, a circular spiral could begin, and be very difficult to recover from. QE2 is important not only because Wall Street considers it a boon, but also because it will dramatically influence global perception. Right now, QE2 is merely an idea, but by tomorrow we expect it to be a reality. Global leaders have been relatively quiet, but that won't last. Many others may soon follow the plight of Brazil (NYSE: EWZ), and step away from the traditional approach to the global economy. Is it possible that commodities become the new global currency?
Watch out “King Dollar” because you do not have long to live if this keeps up.
Disclosure: no conflicts