Awakening ahead on bond delusion - Part 1 of 2
atimes.com
By W Joseph Stroupe
Washington and London are engaged in the most shortsighted and destructive friendly fire assault on the future of their own government bonds and currencies in recorded history. It is all being done in a vain and hazardous bid to revive their faulted bubble-based economic models that crashed last autumn.
As in any friendly fire incident, they aren't aiming to attack and destroy their own bonds and currencies, but rather they believe they are attacking what they see as the real the enemy, collapsed international confidence, with what they see as their most advanced weapon - colossal spending. But their weapon's guidance system has gone haywire and it now has their own bonds and currencies in the crosshairs.
What it really means
By enacting their present shortsighted monetary and economic policies, they are only working to seriously undercut, for the foreseeable future, international confidence in their own bonds and currencies. Confidence in the dollar is very weak and getting much weaker as a safe store of wealth beyond the short term. In proof of this, the recent mere modest return of risk appetite has resulted in investors selling off the dollar for safer stores of wealth in the hard asset-oriented investment world.
As a result, the dollar has declined sharply, with the US dollar index losing 11% since its 2009 high on March 9, the same day the ongoing Wall Street stock rally began. Thus, global investors are loath to hold too many dollars. This is the handwriting on the wall for Washington and London, and it is the hand of global investors, including the central banks across the globe, that is doing the writing.
For the US and Britain: if the dollar symbolizes the monetary policies of Washington and London, then the two are seriously risking irretrievably breaking the backs of their own government bonds with the dollar. This is occurring at a time when the two are more dependent than ever upon continued foreign lending for their present financial and economic stability and that in the foreseeable future.
For the globe's lenders: the increasingly grim outlook for their government bonds and currencies is causing the globe's key lenders to prudently begin to loosen and even break traditional bonds with the dollar for fear of suffering damage as the policies of Washington and London inevitably backfire.
I have stated many times that a new global order in the spheres of monetary policies, finance, economy and trade is arising as the old order that revolved around the US, the dollar and the developed economies gives way to a new order that revolves instead around the emerging economies and their currencies.
The mounting international short-to-medium-term predicament for the dollar and the pound and for US and British government bonds opens the door to genuine transition to a new order that no longer revolves around these as the center, if it turns out that the emerging economies do find effective ways to circumvent their reliance upon the US and the dollar by collectively establishing themselves as a new and vibrant core.
A relative few observers can already see the emergence of such a new order-in-the-making, but many others cannot yet see their way around the outdated conventional wisdom and popular assumptions that are oriented around the notion that, despite present US troubles, global finance, monetary policies and trade still extraordinarily revolve around it as the unchanged center. They also point out that, in their view, China and the other under-developed economies are at present, and will be for a long time, inordinately dependent upon the US and the dollar. These observers therefore conclude that talk of any transition to a new global order is therefore much over-stated.
In this article I will address the popular notions that still blind many to the accelerating emergence of a new global order so the reader can see if they truly stand up to the scrutiny of rapidly unfolding developments on the global stage. If they do not stand up, then such observers will be faced with a decision - will they be willing to change their view of where the global order is heading and how rapidly it will arrive at its destination, or will they refuse to see the handwriting on the wall?
As an admonition to such ones, note carefully the June 12, 2009 statement of none other than Mohamed El-Erian, chief executive and chief investment advisor of Pacific Investment Management Company (PIMCO), the largest bond fund in the world, in addressing the accelerating rise of BRIC (Brazil, Russia, China and India) and other key emerging economies, and the simultaneous noteworthy decline in the global economic leadership and leverage of the developed economies:
The rebalancing of relative economic power is not only alive but gaining momentum ... Average investors need to make sure that they are not hostage to an outdated conventional wisdom that underexposes them to this phenomenon.
In view of this statement, emanating from such a highly-respected authority, the reader will do well to carefully consider all the facts relevant to this issue in the remainder of this article.
Talk begins to turn into action
Especially since February this year, the safety and desirability of holding too many dollars and US Treasury bonds has come under unprecedented verbal fire from a chorus of big foreign lenders to the US. Now, with the yield curve on Treasuries steepening to a record and the dollar declining ever faster as the US Treasury floods the market with huge sums of new issuance, investors are starting to sell off dollars for hard asset-oriented investments in the emerging markets, which many see will be the first to emerge from this global crisis.
Mounting fears over inflation and its power to ravage investors' holdings in the dollar and Treasury bonds are causing investors to do just as PIMCO founder Bill Gross recently warned them to do - move now to diversify their dollar holdings before the world's central banks soon begin to do so in earnest.
We are now rapidly approaching the stage where the central banks really begin to put their money where their mouth has been. How so?
Central banks have been talking a lot recently about the unacceptable risks of too great an exposure to the dollar and to the longer-dated Treasury bonds, but at the same time their rate of purchases of Treasuries has been quite high during this same period, though still below their record rate of purchases in 2008. Their continued purchases mask a vitally important and new strategic shift on the part of central banks.
Thus, when analyzed carefully, their continued buying of Treasuries turns out to be cold comfort for US government bonds and for the dollar itself. What is the strategic shift? Almost without exception central banks have switched from buying the medium and long-dated bonds to buying short-dated bills instead.
When the central banks do buy the long-dated bonds, it is in much smaller purchases than usual and it is obviously done as a minimal effort on their part to help keep the yield curve from steepening too far too fast and needlessly eroding the value of their holdings while they enact other policies aimed at decreasing their exposure to the dollar. Additionally, they have shifted out of a significant portion of their long-dated agency (Freddie Mac and Fannie Mae) bonds and have purchased short-dated Treasuries instead.
There are good reasons for this strategic shift to the short end. The short-dated assets (T-bills) are much less sensitive to yield escalations such as those we are now witnessing and to being eroded by inflation a little further down the road. Additionally, the T-bill market is at present very deep and liquid, thus affording investors the ability to sprint very quickly out of the market and into something else more appealing. The central banks are clearly readying themselves for potential fast action and are protecting their holdings from inflation risks at the same time.
They are also continuing to buy Treasuries for another important reason - to hold their own currencies down against the rapidly declining dollar. Central bank governors don't like risk, and they also don't like rapid changes. In this global crisis they aren't yet willing to let their own respective currencies appreciate too much or too quickly against the dollar, so they have been intervening, buying dollars to keep currency stability, thus protecting their exports from declining too much, as exports most certainly would if they let their currencies rise too much against the dollar.
No sane central bank governor would retreat from a policy of keeping the local currency stable (low) against the dollar in an environment such as this crisis where trade levels have already collapsed - such a retreat now would only doom trade further and risk collapsing the economy. But in their currency interventions, the central banks aren't any longer buying the medium or long-dated Treasuries in anything approaching the sums they used to. Instead they are largely buying the shorter-dated Treasuries.
This is a very significant change - they have collectively soured on further exposing themselves to the rapidly mounting risks associated with medium and long-dated bonds. In basically refusing to accumulate significantly more of such risky assets that are subject to the ravages of inflation, they are signaling that they are actually positioning themselves to significantly divest of such risky assets.
In view of all the factors and developments detailed above, the fact that the world's central banks have until now kept buying Treasuries (mostly T-bills) is indeed cold comfort for the declining dollar and Treasury bonds. Yields on the medium and long-dated bonds are escalating fast as supply skyrockets and foreign demand fades.
The latest data indicate that central bank demand for Treasuries is rapidly falling from its 2008 highs in spite of ongoing purchases. Domestic US savers already account for more than half of all Treasury purchases as the US savings rate spikes. Demand from central banks and other foreign investors isn't nearly keeping up with the new issuance. That is also a very significant strategic shift.
On June 10, yields on the 10-year Treasury notes reached 4% and response to the auction was quite disappointing. The next day, on June 11, response to the auction of $11 billion of 30-year Treasuries was much better, but the yields had escalated to 4.84% at one point before the auction, in which the bonds sold at 4.72%.
These rapidly escalating yields on the longer-dated Treasuries signal that investors are demanding an ever-higher risk premium before they will lend to the US government. As yields continue to escalate, as they almost certainly will in view of mounting fears over the US monetary and fiscal position, the impetus will only increase for large foreign holders of such assets, like the central banks, to further slow their purchases of Treasuries and to begin to divest of the medium to long-dated bonds further and faster.
But haven't a few key central bank governors come out with very dollar-supportive public reassurances in the last few days, stating that the fundamentals of the dollar are still good and that no imminent replacement for the dollar is available? Yes, Russian, Chinese and Japanese officials have done so in the last few days.
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
Jim |
