Dumping the Dollar

This might be the biggest news item of the year:

It Looks Like U.S. Government Bonds Aren't Supported By China Anymore
Business Insider
By Vincent Fernando
August 20, 2010

Earlier this week we highlighted how cut its holdings of U.S. government bonds by the largest ever monthly amount in June. Expanding this thread, it should be noted that China's U.S. debt ownership has fallen to $843.7 billion in June from $938.3 billion in September 200,9 according to U.S. Treasury Department released Monday. This equates to nearly an 11% reduction by China.

Yet interestingly, the 10-year U.S. treasury yield has fallen over the same period, despite the meme that China's voracious U.S. debt buying supports keeps America's bond yields low. (Note that China's U.S. debt holdings encompasses more than just ten-year U.S. bonds, however. )

Now, obviously China continues to support the market by owning a vast quantity of government bonds, in fact the most of any nation as of June, but China's reduction in treasury holdings since September 2009 seems to imply that U.S. treasury yields can fall, and thus treasuries rally, even as China pares back its ownership substantially (11% is a lot for less than a one year period).

This makes the U.S. government bond rally, or bubble depending on your view, even more peculiar. You can't blame it on China propping the market with its standard dollar-recycling activities anymore, it seems.

The “paradox” of declining yields and declining Chinese demand dissolves once one grasps the real forces at play. As a perspective commenter (“Jonathan”) notes,

You won't say what's right there in the open and beyond blatantly obvious. It's not peculiar what's happening, it's trivially easy to figure out.

It's the Fed supporting the US Government bonds directly. In fact, the only thing keeping the US Government from being eaten alive by its debt is the Fed; the only keeping the housing market from absolutely collapsing into the abyss is the Fed holding down rates. There isn't any other sovereign power on earth that is still buying large quantities of US debt (nobody can afford their own debt much less ours too). Only one entity has the purchasing power and the clandestine ability to be doing this without it showing up on the data sheets.

In other words, China has begun its pull back from supporting the US dollar to infinity, and will begin to allow the dollar to collapse through dilution as they hedge off their dollar holdings. The next 24 months will bring substantial real inflation accordingly, easily traced by jumps in the price of commodities.

The game is nearing an end.

I have two points to add.

  1. The Fed might consider its strategy necessary, but it’s inherently self-defeating. The Central Bank can increase demand for U.S. bonds by, essentially, creating money out of thin air and buying up Treasuries. In the short term, this will force rates down; indeed, since the Fed can create unlimited amounts of funny money, it could push rates down quite low. But only for a time. At some point, foreign buyers will grasp that the Fed’s actions are inflationary, and they’ll demand much higher interest rate, or else exit the market, much like China is doing. The “end game” Jonathan refers to is that point at which the Fed is the only major buyer in the U.S. bond markets: a bizarre situation in which the rates on U.S. debt might be forced down quite low through the Fed’s infinite buying power, while outside the U.S. debt market, the economy is experiencing extremely high interest rates and runaway price inflation.
  2. In June, people like Tim Geithner, Larry Summers, and Chuck Schumer were praising Beijing’s announcement of its decision to remove the Yuan’s long-standing currency peg to the dollar and allow floating exchange rates. (See my post “The End of Chimerica.”) It was assumed that the dollar would weaken vis-à-vis the Yuan, making American exports more attractive and helping to rebuild America’s manufacturing base. (Whether these economists actually believe this is an open question, but let’s assume that they do.) The most direct way for Beijing to maintain its currency peg (which entailed suppressing the value of the Yuan) was for it to print Yuan and buy dollars, most often in the form of U.S. Treasuries. (The currency peg was, in this way, a central component of the “Chimerica” arrangement of massive U.S. government and consumer indebtedness and low-wage Chinese manufacturing.) The problem is, ending this arrangement will likely lead to something far more dramatic than a putatively advantageous weak dollar -- a serious collapse in the bond U.S. market.

“Jonathan” put it best, “the game is nearing an end.”