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In the 1960s, French politician Valéry d'Estaing complained that the
United States enjoyed an "exorbitant privilege" due to the dollar's
status as the world's reserve currency. He had a point.
Because the dollar is the world's currency, the US can borrow more cheaply
than it could otherwise (lower interest rates), US banks and companies can
conveniently do cross-border business using their own currency, and when
there is geopolitical tension, central banks and investors buy US Treasuries,
keeping the dollar high and the United States insulated from the conflict. A
government that borrows in a foreign currency can go bankrupt; not so when it
borrows from abroad in its own currency ie. through foreign purchases of
US Treasury bills.
The dollar is the most important unit of account for international trade,
the main medium of exchange for settling international transactions and the
store of value for central banks. The Federal Reserve is the lender of last
resort, as in the 2008–09 financial crisis, and is the most common currency
for overseas borrowing by governments and businesses.
Wall Street generates significant income from selling banking services in
USD to the rest of the world, and the US manages the world's most important
settlement systems, allowing it to monitor and limit funds used for illegal
activities.
Barry Eichengreen, author of ‘Exorbitant Privilege: The Rise and Fall
of the Dollar and the Future of the International Monetary System’, names
three unique attributes to the dollar that no other currency has. As
quoted by DW, these are:
- Size: Due to the size of the US and its economy, there
are more dollars available than other currencies.
- Stability: US Treasuries have historically been valued
as a safe financial instrument that is backed by the US government,
which pays its bills on time.
- Liquidity: Treasuries can easily be bought and sold
without them losing much of their value, given the consistent strength
of the dollar. The bond market for US Treasuries is considered the most
liquid financial market in the world.
Shunning the buck
The dollar is still the reserve currency, but how important is it right
now, with all that is going on in the world? Such as: trade wars, central
banks dumping Treasury bills and buying gold, US interest rates likely to
fall and take the greenback down with them, and President Trump’s preference
for a low dollar in order to cheapen US export prices and narrow the $891
billion trade deficit racked up in 2018.
Fortunately, we have a tool to measure the dollar’s popularity, but for
dollar watchers, it’s not looking good. Every quarter the International
Monetary Fund (IMF) releases a report on global foreign exchange
reserves.
According to the IMF report, the dollar’s share of global foreign currency
reserves in Q2 2019 fell for the sixth straight quarter, to the lowest level
since 2013. Tellingly, the fall corresponds to when Trump took office as the
44th president. In January 2017, Trump’s inauguration, the ratio was 65.4%.
In the first quarter of 2019 it was 62.5% and in the second quarter it
slipped to 62.3%.
That may not seem like a big deal, just two-tenths of a percentage points
between Q1 and Q2, but the slide becomes more significant when one realizes
that the dollar was rallying at the same time as the ratio was
falling. Indeedthe USD enjoyed a huge rally in the second quarter,
surging 4.52%. That means holders of US dollars including central banks,
sovereign wealth funds, etc., were selling dollars even while the value of
the USD was climbing. Why would they do that? Likely they figured the dollar
would in fact fall, longer term, therefore it was a good time to exit
positions.
In providing these IMF figures, Bloomberg notes the last time mass dollar
sales corresponded with a rise in the buck, was in the final three months of
2008 - when there was perceived to be a high risk of the global financial
system collapsing.
We aren’t suggesting that is going to happen but…
The fact that the dollar’s share of global reserves edged lower in the
face of a big rally may be a clear sign that foreign central banks, sovereign
wealth funds and institutional investors see increased risks from holding
dollars as the U.S. government rams up its borrowing to unprecedented levels
to pay for what is soon to be a $1 trillion budget deficit. - Bloomberg
Consider that the US debt is currently over 22 trillion dollars
and climbing, and is running a budget deficit 3.7% of GDP - the
highest ratio in the developed world.
Bloomberg notes it shouldn’t be that big a problem because the US can just
pull a Ben Bernanke and “helicopter in” trillions worth
of newly-minted currency to pay off the debt - something it alone
can do as the holder of the reserve currency.
However, it also quotes JPMorgan Chase & Co. strategist
Marko Kolanovic, who argued in a report this week that Trump’s
isolationist foreign policy is a “catalyst for long-term
de-dollarization.”
Put another way, the dollar is in jeopardy of no longer being the
world’s primary reserve currency and enjoying the “exorbitant privilege” that
goes along with that, such as interest rates that are lower than they might
otherwise be and the government being able to fund budget deficits in
perpetuity.
“With the current U.S. administration policies of unilateralism, trade
wars, and sanctions increasingly affecting both friends and foes, the
question arises whether the rest of the world should diversify away from the
risks of the U.S. dollar and dollar-centric finance,” Kolanovic and
his team of quantitative and derivatives strategists wrote in a research
note.
Buying gold
Bloomberg presents an interesting story of how central banks and other
very large institutional investors are slowing their dollar buys amid US
dollar strength. But the news service doesn’t go far enough in discovering that,
as they’re dumping dollars, central banks are buying gold. We wrote about
that last week in Why
are central banks buying gold and dumping dollars?
Why are they buying? Gold prices usually go up when real interest rates
turn negative, in other words, when interest rates minus the rate of
inflation go below zero. While we aren’t there quite yet, taking a
look at the 10-year benchmark Treasury yield reveals a rate of interest
that has been dropping for some time.
Central banks purchase US Treasuries to bulk up their foreign exchange
reserves. They do this especially during periods of unrest, or when the
economic forecast is bleak. Gold’s role as a safe haven is
well-documented. Of courseTreasuries are as much or more sought-out by
investors in a crisis or pending crisis, but lately, Treasuries have become
much less popular as a means of storing wealth.
According
to the World Gold Council, central banks are continuing a buying spree
that started in 2018. A total of 651 tons of gold was accumulated last year,
74% more than 2017 and the highest amount since the end of the gold standard
in 1971.
So far in 2019, central banks have squirreled away 207 tons in bank
vaults, the highest year-to-date purchases since central banks became net
gold buyers in 2010. (before that they were net sellers, selling more gold
than purchased).
Awful bond yields
The reason is simple: T-bills don’t offer a good return, and neither do
other sovereign debt instruments - five important central banks are currently
offering negative rates.
Looking at the 10-year yield chart, we see the yield starting to go down
last November, falling steadily all the way to its current 2.02%. Subtract
1.8% inflation and the real yield, just 0.22% begins to
look pretty skinny.
There’s an old saying on Wall Street “Six percent interest will draw money
from the moon.” And it’s true, but what is also true is 1. As long
as real interest rates are below 2% gold is in a bull market and 2. Real
interest rates below 2% draws investors to gold.
Central banks know this, so do educated gold buyers.
With Treasury bills paying such low net yields, gold becomes an attractive
investment. And while the precious metal offers no yield, its status as an
inflation hedge and store of value not subject to fiat currency manipulation
are good reasons for central banks to purchase gold.
It doesn’t take an economist to see what’s happening here. Central banks
see Treasury yields slumping and real yields low, and likely on their way
negative, so they are backing up the truck for gold. They see gold continuing
to increase in value.
Danger ahead
Why are Treasury yields falling? Well, the prices of bonds run inverse to
their yields, so in times of economic uncertainty, bond investors “dance
a little closer to the exits.” They park their money in short-term
Treasury bills rather than going long, because they aren’t too confident in
the outlook for the US - a $22 trillion debt burden and annual deficits
running close to 4% don’t help. This causes the yield curve to invert -
meaning the rates for short-term bonds are higher than longer-term bonds,
normally it’s the opposite. The yield curve is an extremely accurate
recession predictor. In the last 60 years, the yield curve has presaged every
recession. The yield curve between the three-month and 10-year Treasury yield
has been inverted since mid-May.
A number of other key economic indicators are blinking “caution” for
investors.
US unemployment is at record lows but the job numbers are
indicating a shift. The country created 75,000 jobs in May, well off the
expected 185,000.
The trade war is far more serious than a year ago when the first tariffs,
on aluminum and steel, were enacted. Tariffs now encompass over half of the
roughly $500 billion in goods that China exports to the US, and
almost all American goods imported by China.
Uncertainty over the trade war is having an effect on business leaders who
are deferring strategic decisions and in some cases, rejigging their
supply chains.
Morgan
Stanley reported a rapid deterioration in US business confidence. The
investment bank’s gauge of business conditions fell 32 points, the biggest
drop since the financial crisis.
The PMIs for US services and manufacturing in May were the worst since
recessionary 2009 - adding to the sentiment that US economic growth is
slowing.
As for the US Federal Reserve, its board of governors last week sent a
strong message that a rate cut is being considered to bolster the flagging
economy - a complete 180 from six months ago when the US central bank was
looking at further raising interest rates.
Why cut? The Fed is concerned about low global growth, disturbingly weak
1.8% inflation, and a cartload of other signals that we are heading into a
recession.
The latest data to support a cut showed first-quarter home sales falling
to a five-month low. Consumer confidence slumped to its lowest level since
September 2017. The latter is important because consumer spending makes up
two-thirds of US GDP.
“Crosscurrents have re-emerged, with apparent progress on trade turning to
greater uncertainty and with incoming data raising renewed concerns about the
strength of the global economy,” Fed
Chair Jerome Powell said Tuesday, ahead of a speech to the Council on
Foreign Relations in New York.
Why buy a “bund”?
Global tensions such as a war with Iran, the fear of a Brexit hard
landing, unresolved trade disputes and anemic global growth, to name just a
few problems, are forcing investors into safe havens like government bonds,
even though their rates are abysmal.
The dramatic bond rally we are currently seeing, is driving down yields
across the world (bond prices and yields move in opposite directions).
Investors are piling into sovereign debt based on expectations of new
monetary stimulus similar to earlier quantitative easing programs
that pushed down interest rates to zero and sparked a global bull market in
stocks, that is still going 11 years later.
A lot of the debt being taken on has negative interest rates. Last week,
the value of debt being offered at a negative yield increased by nearly $1
trillion. According to Bloomberg, bonds with sub-zero debt yields now make up
an astounding 25% of the bond market, and nearly 40% of the sovereign debt
market.
Germany auctioned its 10-year “bunds” for the lowest yield on record -
negative 0.24%. Quite a fall from the 2.9% rate of interest the bonds
commanded in January.
All the uncertainty around Britain leaving the EU has apparently damaged
Europe’s largest economy; its manufacturing sector is reportedly heading for
a recession.
Purchasers of German debt are almost guaranteed to incur a loss if they
hold them until maturity. So why buy them? Fear. The global economic outlook
is so scary, they would rather park their money in negative-yielding
debt.
Investors
are holding their noses and buying bonds now, before rates go any lower. As
the Financial
Times reported, “highly rated bonds” like Germany’s “bunds” and US
Treasuries, “have rallied in recent weeks as concern over the global economy
- heightened by the US-China trade dispute - has sparked expectations that
major central banks will assume a more dovish posture.”
Reuters
points out that reducing interest rates or at least sounding off on
the possibilities, is “in vogue at the moment.”
The news service notes that, along with the Fed, the ECB and the Bank of
Japan pursuing a dovish monetary policy, so are emerging markets, such as
India and Russia which have already started easing. Indonesia, the
Philippines and Brazil have flagged interest rate cuts in the near
future. Switzerland, Japan, Sweden and Denmark have all gone to negative or
near-negative interest rates, to try and spur growth and to stimulate
exports.
The monetary doves are clearly in control.
Dumping Treasuries
We started off this article noticing how central banks and other
institutional investors have been selling US dollar foreign exchange
reserves. This trend corresponds to another related trend we see happening -
central banks are off-loading their US Treasuries.
Here’s how
the two are related: When a country’s exporters receive dollars for their
goods sold to the US, the central bank converts the dollars into its home
currency, then places that money into their foreign exchange (forex)
reserves. They then plow that forex into a safe haven, US Treasury
bills.
March saw a big sell-off of US T-bills held by foreign central banks, due
to the factors we’ve outlined - low yields, especially on long-term bonds,
and concerns that interest rates are going to fall, further depressing
yields.
South
China Morning Post notes that in total, overseas investors in March
sold a net $12.5 billion in Treasuries and $24 billion in US stocks.
Surprisingly, the biggest seller was Canada, dumping $12.5 billion worth of
securities, the most since July 2011.
China - by far the largest holder of US Treasuries - in March sold
the most in 2.5 years, $20.45 billion, and that was before the
United States increased tariffs on $200 billion worth of US-bound Chinese
goods from 10% to 25%. It’s possible that Beijing has ordered the sale of
more Treasuries as retaliation against US tariffs.
Recall what we said earlier, that central banks are dumping their dollars
and buying gold. The Chinese central bank has added to its gold reserves
every month of the last six. Since December the People’s Bank of China has
expanded its gold holdings by more than 70 tons.
Russia
is a dramatic example of central banks getting out of dollars and
into other assets. In one year, between September 2017 and September 2018,
the Russian central bank sold off over half of its foreign-currency assets
denominated in dollars, and “sharply increased the shares of the euro and the
renminbi.”
Russia is also the leading buyer of gold. Last year its central bank
stocked up on 274 tons of the precious metal, accounting for 40% of central
bank buying. Bullion now represents about 19% of its forex, the most since
2000.
As the target of US sanctions, Russia sees diversification from the dollar
and into gold and other currencies, as a way of skirting trade
restrictions.
It’s also worth mentioning that, as central banks become less weighted
with US Treasuries, they
are buying more Japanese yen, Chinese yuan and euros. In 2018 the amount
of yuan, while only representing 1% of global foreign exchange reserves,
doubled from the previous year.
South China Morning Post states that by increasing the share of
gold and Special Drawing Rights – the IMF’s composite currency – in its
foreign exchange reserves, Chinese media said Beijing was shoring up support
to ensure the stability of the yuan.
Race to the bottom
To recap, we have economic indicators not only for the US, but Europe and
China, pointing to a recession in the not-too-distant future. The yield curve
between short and long-term Treasury yields has been inverting. An inversion
has accurately predicted a recession will occur, on average, 14 months later.
We also know oil price spikes correlate even more closely to recessions than
inversions.
All of this is taking place amid a trade war between the US and China,
wherein the US president favors a low US dollar in order to make US exports
more competitive, to correct the yawning trade deficit, and restore American
manufacturing which has been hit hard by cheaper foreign currencies.
Decades of currency stability, when countries had a “gentleman’s
agreement” not to competitively devalue their currencies, may be coming to an
end. President Trump has accused China, Russia, Germany and Japan of
purposely keeping their currencies low - which is ironic because the US has
done the same thing through its rounds of quantitative easing, 2008-15.
Other central banks - Japan and the ECB for example - also employed
bond-buying, as well as interest rate cuts - to stimulate their economies,
after the damage caused by the 2008-09 recession.
Now, slow global growth, caused partly by the trade war restricting global
shipment volumes, as well as a slower Chinese economy, is bringing back
dovish policies like interest rate cuts and bond-buying.
Central banks know about the low Treasuries and other sovereign debt
yields, some even going negative, and are staying away from them. They’re
selling Treasuries and dollars, buying gold, and to a lesser extent, yuan,
euros and yen.
If the US insists on pursuing a low interest rate and a low dollar, its
trading partners will be forced to follow suit and devalue their currencies,
in order to keep competitive, and maintain export levels. Reuters
agrees:
The impact of looser Fed policy may be felt around the world through a
decline in the dollar, which could pressure Europe and Japan to follow suit
to keep their exporters competitive - the makings of the tension over
currency that has plagued G20 meetings before.
“It is hard to see how you get a cooperative outcome,” said Vincent
Reinhart, chief economist at Standish Mellon Asset Management and a former
top staffer at the Fed.
“A trade dispute can become a currency dispute pretty quickly. If what
the United States ultimately wants is a depreciation, I don’t see others
raising their hands and saying I will take the appreciation ... We don’t have
many trading partners that are in a position to share weakness.”
This could lead into a dangerous currency war that nobody wants, with
every participating country engaging in a race to the bottom in order to
out-export, and devalue, its trading partners, who have become
adversaries.
Think about what could happen in a trade war between the US and the other
countries it trades with. Because the States has the reserve currency, it can
simply print more dollars (while keeping an eye on inflation), buy government
bonds and issue more Treasuries, thus adding to the already huge $22 trillion
mountain of debt. The most important thing though is interest rates and the
dollar kept low.
This encourages exporters to make more goods, increasing US GDP.
Manufacturing would thrive, and companies would become more profitable.
However, this would be at the expense of its trading partners. In the long
run, they wouldn’t be able to survive a currency war.
Look at what the US is preparing to do. The Commerce Department has just
been appointed new powers that certainly appear to take the fight with China
in this direction.
France24
reports on a proposed new rule that allows the United States to
impose tariffs on any country it determines is manipulating its
currency.
Commerce is being given a wide scope of power to decide whether or
not a country is manipulating its currency to the detriment of the
United States.
Right now the US Treasury produces a report every six months on
whether any country is manipulating their currency to the disadvantage of the
United States. A finding of currency manipulation “could impose tariffs to
offset the weaker exchange rate against the US dollar,” states France24.
According to the proposal, Commerce said it would defer to Treasury's
evaluation of whether a currency is undervalued, “unless we have good reason
to believe otherwise.”
In other words, if Treasury believes from its evaluation, that a country
is manipulating its currency, the Commerce Department won’t go any further to
investigate. Or at the very least, it’s ambiguous as to what the department
would do to prove it. The Treasury’s finding could conceivably be enough to
move forward with trade sanctions.
So, not only does the US have more fire power than any other nation in a
currency war, it is also arming the Commerce Department with the power to
slap tariffs on any currency that devalues, up to the amount of the
devaluation. If its trading competitors did the same thing, in retaliation,
we could be looking at endless rounds of devaluations and tariffs, that would
eventually destroy global trade.
Or, the countries the United States trades with could decide to cut the
dollar out completely - stop trading with the US and cease buying dollars/ US
Treasuries.
This would mean the end of the US dollar’s exorbitant privilege and its
status as the world’s reserve currency. It would most certainly cause a major
dislocation of the financial system of the likes never before seen
in economic history.
Conclusion
Are we being alarmist? Maybe. But we are already seeing much evidence of
de-dollarization in effect. Since the Fed heavily hinted that it would cut
interest rates in July, the dollar has fallen 2% in a week.
The US Treasury had
to borrow $1 trillion to finance the deficit, the second year in a row
that’s happened, by issuing a trillion worth of Treasury bills. This can’t be
sustainable. What happens if the leak in Treasury-bill buying turns into a
rushing torrent? The United States would be unable to finance its
deficit.
We’ve seen central banks, over the last quarter, giving the brush-off to
near-negative yielding US Treasuries in favor of bonds that offer higher
yields - even risky Greek bonds - and piling into gold, the best safe
haven in times of crisis.
And we’ve witnessed more cooperation between Russia and China, through the
signing of multi-billion-dollar energy deals and currency swaps that water down
the greenback’s influence.
Soybeans are China’s top import from America. A joint
venture between Chinese and Russian companies will invest $100
million over three years to build a soybean crusher and grain port in Russia,
and lease 247,000 acres of farmland to grow wheat, corn and soybeans. The
country is also reportedly building a new port in the northeast that will
ship grain harvested in Russia by Chinese companies, as part of its Belt and
Road Initiative.
Russia and China have been cozying up in other ways over the past few
years. In 2014 Russian state-owned Gazprom signed an eye-popping $456 billion
gas deal with China. The year previously, Rosneft agreed to double oil
supplies to China in a deal valued at $270 billion, and in 2009 Russian oil
giant Rosneft secured a $25 billion oil swap agreement with Beijing.
2014 was also the year that China really started to move away from the
dollar. China agreed with Brazil on a $29 billion currency swap in an
effort to promote the Chinese yuan as a reserve currency, and the
Chinese and Russian central banks signed an agreement on yuan-ruble swaps to
double trade between the two countries. The $150 billion deal, one of 38
accords inked in Moscow, is a way for Russia to move away from U.S.
dollar-dominated settlements.
The latest evidence of Chinese-Russian business ties involves a new crude
oil futures contract, priced in yuan and convertible into gold. The
Shanghai-based contract allows oil exporters like Russia and Iran to dodge US
sanctions against them by trading oil in yuan rather than US dollars.
That worked pretty well after the financial crisis, when the
world economy was more or less back on track, with no trade wars and tit for
tat tariffs impeding international trade, and the US dollar still carrying
enough heft to enjoy exorbitant privilege.
This time is different. We have an unpredictable president in the White
House that has already done much damage to the world economy, hurt the
relationship between the US and its largest trading partner, and now appears
heading towards a currency war wherein the US and China, and likely Europe,
duke it out over who can out-export the other. One outcome is a gradual race
to the bottom, like a swirling drain. The other is for America’s trading
partners to punt the dollar and go with a basket of currencies like Special
Drawing Rights (SDRs), possibly backed by gold.
In the meantime, a quote
from The Mises Institute, via Zero Hedge, frames pretty well the
situation we are in:
Political money will unravel; commodity money will reassert itself.
Central bankers will force depositors into the bizarro-world of negative
interest rates, destroying capital and dramatically hurting savers. Central
bankers similarly will do everything they can to avoid a stock market crash.
They will once again buy assets and prop up equities, while telling us their
fiat currencies are healthy—even as they quietly buy more gold than they have
in decades.
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Mills has based this document on information obtained from sources he
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accepts no responsibility or liability as
to its accuracy or completeness. Expressions of opinion are those of
Richard Mills only and are subject to change without notice. Richard Mills
assumes no warranty, liability or guarantee for the current relevance,
correctness or completeness of any information provided within this Report
and will not be held liable for the consequence of reliance upon any opinion
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