Page 2 of 2 Awakening ahead on bond delusion
By W Joseph Stroupe
Does this mean that all the fears over the dollar and Treasuries detailed here
are perhaps over-blown? Not if you judge by their actions rather than by their
ostensibly reassuring words, which always seem to suddenly appear when the
dollar's decline quickens on news that they are taking dollar-negative steps to
limit their exposure, as is now the case.
It must be remembered that these central bank governors and finance ministers
have a vested interest in talking the dollar back up from its accelerating
decline with the aim of protecting their holdings while they work mostly under
the radar to diversify their reserves.
The fact that a number of key finance officials in Russia, China
and Japan have suddenly rushed to make such reassurances betrays the depth of
their underlying concerns about the stability of the dollar and their excessive
exposure to it. By their public assurances they are attempting to paper-over
the deeply worrying fundamentals of the dollar and Treasuries so that they can
quicken their pace behind the facade, working harder and faster to diversify.
To summarize, two interrelated strategic shifts of major importance have
already occurred in the sphere of international lending to the US:
Foreign investors, including most notably central banks, have massively soured
on buying and holding medium and long-term Treasuries and other dollar assets,
making their purchases at the highly-liquid short end instead.
Generally the same group (foreign investors) has refused to step up to buy
satisfactory sums of all the new issuance now flooding the market. Instead,
domestic US savers along with some private foreign investors already represent
at least 50% of demand, with that group accounting for a rapidly increasing
share of demand, while central banks account for a rapidly decreasing share of
demand, in spite of their ongoing purchases at the short end.
As if this wasn't dour enough for Treasuries and the dollar, other new and
potent factors are arising to make Treasuries and the dollar even much less
appealing for anything beyond the short term.
Strategic outlook fuels urgency
While global investors generally are hoping to see the Federal Reserve shift
its quantitative easing (QE) policy into much higher gear by significantly
stepping up its purchases of the longer-dated Treasury bonds and thus bring
down yields, that is generally not the position of the central banks. The
central banks take a longer view of matters and see the huge currency risks
associated with QE.
Especially if the Fed soon shifts QE into high gear in a risky bid to regain
control of escalating yields, a very potent debasement of the dollar will
result. Exiting from the policy when hyper-inflation rears its ugly head will
be very problematic for the Fed. A full-blown dollar crisis could well result
only a very few years down the present path. Hence, the central banks generally
don't want the Fed to continue down this risky path. But if it does, or even
shifts QE into higher gear, the central banks will gain even much greater
impetus to divest of their longer-dated dollar holdings.
In addition to these potent factors that increasingly make investors loath to
hold the dollar and government bonds, we must consider the rapidly worsening
effects upon the US financial and economic sectors of escalating bond yields
and mortgage and other interest rates.
We know this crisis has been fueled mostly by the rupture of the housing bubble
in the US. House prices are still in a freefall, despite nonsense in the media
about "green shoots" and the bottom of the housing collapse being in sight.
This crisis will not turn around for the US and Britain unless and until
housing prices cease their collapse and begin again to ascend. But escalating
bond yields and mortgage rates are powerfully threatening to accelerate the
collapse in housing prices.
Credit is now getting costlier and is now even being choked off for prospective
home buyers and those wishing to refinance. This in turn puts more heavy
downward pressure on home prices in addition to the immense downward pressures
already in place. As home values continue to collapse more foreclosures will
result. Consumer spending in other areas of the economy receives a big negative
hit as well, and businesses and banks suffer ever greater losses, feeding into
greater job losses as the cycle feeds back into itself.
At the same time, the ongoing global sell-off of dollars for hard assets as a
hedge against the weaker dollar and inflation is causing commodities of all
sorts to surge in price. If this dollar sell-off continues, and if the emerging
economies continue to lead the rest of the world out of this crisis (even if
they do so slowly), then this portends that the US will be obliged to import
inflation from abroad.
You have the very real potential of a stagnation or even an ongoing contraction
of the US economy, but with a simultaneous raging inflation - stagflation.
Thus, due to these potent negative mechanisms there is every likelihood that
the US financial and economic sectors will become more depressed and much less
stable.
Step back for a moment and take a hard look at the worsening fiscal position
and strategic outlook for the US This will help the reader to see matters as
the central bank governors around the world increasingly do.
Even though economic indicators recently show some signs of stabilization in
nonfarm payrolls, manufacturing sentiment, oil prices, and car sales, these
signs are still very tentative and feeble. Many of these indicators remain
worse than anything experienced in the postwar period.
Of course, considering the sheer colossal sums of government propping and
stimulus, the US economy may well soon enjoy a temporary and feeble rebound,
but the strategic outlook remains grim. The implosion in the federal
government's finances is unprecedented, raising very grave questions about how
the exploding government deficit will be brought under control. The US and
other countries are borrowing huge new sums with no indication that the economy
is growing, or that it will grow anytime soon to a sufficient degree so as to
be able to service the Mt Everest of new debt that is being racked up.
All this government spending and the costs of servicing that debt will have to
be subtracted from future growth prospects as the bill for all of it inevitably
comes due in the form of higher taxes, higher interest rates, higher inflation
and a much weaker dollar.
The strategic outlook for the US, Britain, and for a number of other developed
economies that are moving along a similar path is indeed grim. So those who at
present point to the fact that auctions for Treasuries haven't yet failed are
entirely missing the point - they are missing the ominous handwriting on the
wall that is being written by the world's big foreign lenders in the form of
the steepening yield curve.
The handwriting warns the developed economies that racking up huge new sums of
debt and then monetizing that debt via a shortsighted policy of quantitative
easing very seriously risks breaking the backs of the dollar, of government
bonds, of what's left of international confidence in the dollar, and of the
lenders' traditional bonds (ties) to the dollar as a consequence.
The successful Treasury auctions, so far, are thus a bad thing as they allow us
to continue to delude ourselves that all this debt is still all right.
Remember, a similar set of delusions resulted in the emergence of the very
global crisis we now find ourselves in.
Hence, the real danger is that global investors may soon begin to evaluate the
dollar based much more upon the potentially grim fundamentals of the US
financial and economic sectors, as they are already evaluating the dollar on
the increasingly worrisome prospects for inflation eroding the currency's
value.
If the US economy is pushed into a scenario of deeper recession/depression by
the out-of-control escalating yields and interest rates triggered by the
out-of-control government spending as detailed above, then a new round of
global risk aversion on the part of investors could result. But this time
around, the dollar might well take center stage, not as a safe haven in the
storm but rather as the epitome of unacceptable risk.
Yes, next time around, instead of the dollar serving as the answer to risk
aversion, it may serve as the cause. This is specially so if investors come to
see the hard-asset oriented investments in the emerging economies as better
stores of wealth than a rapidly declining dollar. As we shall see later in this
article, the emerging economies are weathering this storm much better than is
the US. At some point global investors may become sufficiently repulsed by the
dollar's mounting troubles that they refuse to give it the nod as a safe haven
in any new storm.
US officials are watching the escalating bond yields, the rapidly declining
dollar index, the mounting ill effects of these on credit and the financial and
economic sectors, the increasingly vocal fears and criticisms being expressed
by global lenders (central banks), and the strategic shifts in their pattern of
lending to the US. They have to be profoundly concerned that just such a new
storm may be about to break forth.
Those in the US who like to harp on the fact that purchases of Treasuries
"continue" and that Chinese and other central banks are "stuck" with the dollar
have an eventual rude awakening in store for themselves. China isn't stuck with
its present high levels of exposure to the dollar. It has a range of effective
options which, over a relatively short period of time of a very few years, will
enable it to significantly decrease its exposure to the dollar and roll back
its reliance upon the dollar and the US market in ongoing global trade. The
same is true for other central banks in Russia, India, Brazil and across the
emerging markets.
Next: Potent options in emerging markets W Joseph Stroupe is a strategic forecasting expert and editor
of Global Events Magazine online at www.globaleventsmagazine.com
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