Dollar strength is an illusion

I have felt for sometime that dollar strength is a counter-trend that has a sell-by date written all over it. You see, the Federal Reserve is ballooning its balance sheet like nobody’s business as it tries to be the global lender of last resort. This is very inflationary. Apparently, the Fed wants to trash the Dollar. And, despite recent events, I believe it will eventually get its wish.

The United States is the world’s biggest debtor nation, dependent upon foreign governments to buy treasury and agency debt in order to maintain itself. However, two articles I read today have convinced me that this situation is about to change in a nasty way and Asian countries are about to let the dollar go (very big hat tip Scott).

The first article concerns Taiwan and their apparent desire to stop buying agency debt for fear of throwing good money after bad.

Taiwan’s financial regulators reportedly have ordered that nation’s insurance companies to pare their holdings of the debt and mortgage-backed securities of Fannie Mae (ticker: FNM), Freddie Mac (FRE) and Ginnie Mae securities, according to a report on the Internet site of Asian Investor magazine.
Such an order would be a stunning rebuke to Washington, coming a little more than a month after the federal government effectively nationalized the mortgage giants. Fannie and Freddie last month were placed into conservatorships with the Treasury standing ready to inject up to $100 billion through purchases of preferred shares in the government sponsored enterprises.

As a result, Fannie and Freddie debt has the “effective guarantee” of the U.S. government, a spokeswoman for the Federal Housing Finance agency, the regulator for the GSEs, said Thursday. (That was a “clarification” of FHFA director James Lockhart’s earlier declaration to the Senate Finance Committee that Fannie and Freddie debt had the “explicit” guarantee of the U.S. Treasury, Dow Jones Newswires reports.)

Moreover, Ginnie Mae securities have always been backed with the same full faith and credit guarantee as the U.S. Treasury.

In either case, the Taiwanese action is a blow to the reeling U.S. mortgage market, which has been supported by the Republic of China’s purchases of agency securities. According to U.S. Treasury data, Taiwan owned a very substantial $55 billion of U.S. agencies along with $43 billion of Treasuries as of June 30, 2007, the most recent date for which these data are available.
Randall Forsyth, Barron’s

This certainly is bad news for U.S. interest rates, mortgage rates and the U.S. Dollar. However, more worrying s that mainland China seems to be following its Taiwanese brothers in rejecting the U.S.

The United States has plundered global wealth by exploiting the dollar’s dominance, and the world urgently needs other currencies to take its place, a leading Chinese state newspaper said on Friday.

The front-page commentary in the overseas edition of the People’s Daily said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies.
A meeting between Asian and European leaders, starting on Friday in Beijing, presented the perfect opportunity to begin building a new international financial order, the newspaper said.

The People’s Daily is the official newspaper of China’s ruling Communist Party. The Chinese-language overseas edition is a small circulation offshoot of the main paper.
Its pronouncements do not necessarily directly voice leadership views. But the commentary, as well as recent comments, amount to a growing chorus of Chinese disdain for Washington’s economic policies and global financial dominance in the wake of the credit crisis.

China is the largest holder of U.S. government and agency debt. If they go on strike, the consequences for the U.S. would be catastrophic.

It is hard to believe we are asking this, but events are pointing in an ominous direction: Is the U.S. Government even solvent?

  1. hbl says

    How sure are you that the Fed’s expansion of its balance sheet is inflationary in the short term? I’m under the impression that broad money supply is contracting via The Great Deleveraging faster than base money is being increased via the Fed’s balance sheet growth. Isn’t it broad money supply that counts the most with respect to the overall supply of dollars available for exchange, and hence the price of the currency?

    However I do agree that an increased reluctance to hold dollars relative to other currencies could trash the value of the dollar.

  2. Anonymous says

    On a Canadian current-events show, The Agenda, well-connected Chinese professor and columnist Wenran Jiang said among other things:

    “They [China] are in a catch-22 situation – they lost big-time, but they must stay in this game, and help the United States. […] We heard a rumour […] that Henry Paulson has been calling China on a daily basis in the past few weeks, since the crisis struck, and saying, ‘Don’t sell anything. Don’t go away.'”

    He implied the rumour came from sources in the government. I believe him.

    Show details, including an audio link — most of the first 20 minutes is very very elementary, just defining terms; then it gets into details of possible G20/IMF changes, nothing too exciting. Jiang seems to have the most new information, from Beijing – his rumour comes around the 25 minute mark.

  3. Anonymous says

    Anyway, about having to ask: of course the US Government is insolvent. They have (as of Sep 30/07) $10t in liabilities and $1.5t in assets, with a $0.4t operating cost in 07 (probably more like $1t this year.)

    But no one can repossess their assets, so all that can happen is monetization of the debt. This happens when the Fed buys bonds directly, which is already planned.

    Here’s a paper from the St Louis Fed Review, December 1984, detailing the process and what effects it might have.

  4. Edward Harrison says


    the Fed’s expansion is inflationary. The definition of inflation is printing more money. But they are running into the Japanese dilemma and that means they are pushing on a string — this is due to the Great Deleveraging that you speak about.

    And it is the base money supply that counts domestically and abroad. The broad money supply is just a manifestation of leverage. The more leverage and credit, the greater the money multiplier and the more effective inflation is.

    The Japanese flooded their economy with Yen, but as no one wanted to lend, the money supply did not expand. In fact, what happened is that money fled the Yen and started a carry trade as domestic investors started to invest abroad.

    Effectively, Japan was exporting its inflation abroad.

    As for the U.S. being insolvent, I am being a bit tongue-in-cheek. When you have the world’s reserve currency, it is pretty hard to default. That does not mean that one is not effectively insolvent.

  5. hbl says

    Thanks for the reply… But even if printing more money is technically inflationary, I guess my main question was what impact such balance sheet expansion would have on the dollar from a money supply perspective (independent of the demand side). If the new base money is being horded rather than lent out (which happened in Japan if I understand correctly and is happening in the US so far), then broad money supply overall (base + credit) can still shrink… So from a currency supply perspective the dollar could see continued support, right?

  6. Anonymous says

    hbl: You’re right, but this is base inflation on a scale very rarely seen, and they seem to be pulling out all the stocks (this is what Bernanke has written about for decades, so it would be strange for him to change course now.)

    Once you get to the point where interest rates are at 1%, you’re injecting money directly into various firms, and things are still falling – real interest rates remain high – then you start having to do things like mass purchase Treasuries to try and drive real interest down.

    The problem with that is that you’re then pretty much handing out money to anyone who wants it – there are $10t of Treasuries out there and a whole lot of people who would love some money.

    It also creates a new difficulty in that everyday financing of government debt is a direct counterbalance to treasury yields – you’re hitching program spending directly to the monetary base at that point. You end up with little to no “fiscal space” – the ability for a government to operate without ruining the economy. This is one of those signposts on the road to sovereign default, so it’s highly discussed in IMF/World Bank papers.

    It’s generally considered that at some point along the road people start noticing that money is appearing faster than the Treasury yield — the latest figures for the shadow M3 put it at “only” $14t – so if you need to buy more than $420b ($14t*0.03) of Treasuries in a year to try and keep the yield at (say) 3.00, something’s gotta give. You then have a Bad Time.

    I suggest RMB.

  7. hbl says

    This is looking like a popular topic in many blogs right now! Among others posting today, Roubini devotes most of a post to the topic.

    “So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question is: likely not.”

    Anon 2:03, thanks for the response… I have read Bernanke’s famous speech. Like everyone else, I’m just trying to figure out what actually could happen and succeed given the many constraints (Roubini mentions a couple). Roubini may be wrong about the Fed’s willingness to inflate but his track record has been impressive so far…

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