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What are the
implications for the U.S. dollar and investors’ portfolios if bond prices
continue to fall, as they have of late? Within that context, should investors
care whether the U.S. retains its status as a “reserve currency”?
Should it effect the way
investors think about their own cash reserves?
Until the end of last year, China had been a net
seller of U.S. Treasuries for six consecutive months, spooking some investors
that China might start to diversify its reserves in earnest. That trend was
reversed in January, when its Treasury holdings grew by 0.7% in one month to
$1.159 trillion; year-on-year, China’s holdings increased a mere $4.8
billion. China’s year-on-year increase in Treasury holdings is sufficient
to finance the U.S. current account deficit for about 3 business days; that’s a good
reason why investors should care, as the current account deficit reflects the
amount of U.S. dollar denominated assets foreigners need to buy just to keep
the greenback from falling.
Whereas China has taken a breather with regard to
piling on U.S. debt, Japan has increased its purchases of Treasuries, possibly
because it is eager to weaken its own currency. Japan’s Treasury
holdings now stand at $1.1 trillion. Together, total foreign holdings of U.S.
Treasuries rose 0.9% to a record $5.05 trillion in January.
Unfortunately, foreigners might be attracted to the
U.S. dollar more for liquidity and less so for quality considerations.
Central banks with billions to deploy are able to do so in U.S. Treasury
markets without influencing market prices too much. Think of it as the upside
of issuing a huge amount of debt: there’s lots of it one can buy and
sell. Liquidity, however, doesn’t guarantee success, as the Italian
bond market has clearly shown; when weaker Eurozone countries are engulfed in
a crisis of confidence, Italian bonds have often been sold as a proxy due to
the size and depth of the market. Japan represents another large bond market.
Still, the U.S. bond market dwarfs all of these. When it comes to perceived
safe havens, Swiss government bonds may be hard to come by at times; given
the erratic actions of the Swiss National Bank in recent months and years, we
have to caution that even Switzerland may not be the safe haven some perceive
it to be. Moving to Germany – considered to be a large, mature market
by many – note that even German Treasury bills have been extremely
difficult to obtain during stretches of the financial crisis, even at
negative yields.
Indeed, one of the most positive global developments
would be if emerging market countries develop their domestic fixed income
markets. If governments, particularly in Asia, were to issue more debt in
their domestic currencies, they would be less dependent on U.S. dollar
funding, reducing the so-called contagion risk in a financial crisis.
Ideally, emerging markets would further develop both long-term bond markets,
as well as short-term Treasury markets. The following example illustrates how
global markets are so interrelated, and why such a development is so important:
currently, a great deal of emerging market financing is U.S. dollar
denominated, but originates from European banks. Those European banks, with
trouble at home, are cutting their credit lines, to both shrink their loan
portfolios, but also as their cost of borrowing U.S. dollars soared.
That’s because European banks historically obtain much of their U.S.
dollar financing through U.S. money market funds. On average, U.S. prime
money market funds held about 50% of their assets in U.S. dollar denominated commercial
paper issued by European banks. After lots of public scrutiny, including from
us (see: Making the U.S. Dollar Safer: Return OF Your Money), those holdings fell to about 1/3rd of money
market fund assets in late 2011. As U.S. money market funds reduced their
appetite for debt issued by European banks, the Federal Reserve (Fed), in
conjunction with other major central banks, put in place “central bank
liquidity swaps”, a fancy way of describing U.S. dollar loans extended
by the Fed to the European banking system via the European Central Bank (ECB)
to alleviate U.S. dollar financing concerns and ultimately, contagion risks
to the global economy.
A key attribute of liquidity is the ability to take
money out of a country. An investor will be more willing to invest in a
country when there are no capital controls, when there’s confidence in
the rule of law, confidence that investors’ rights are protected. And
while emerging markets are generally on the right path, it’s a path
that takes a long time to build, as investors’ trust must be earned
over many years.
As such, odds are the reserve currency status of the
U.S. is likely to erode over time rather than overnight, if for no other
reason than the lack of suitable alternatives. In our view, however, U.S.
policy makers would be well served if they attempted to make the U.S. dollar
as attractive as possible, rather than relying on the fact that foreigners
have limited alternatives. As recent years have shown, the Chinese, for
example, have gained operational experience in deploying their reserves into
assets outside of U.S. Treasuries, in real assets, throughout the world:
notably by investing in natural resources in Australia, Africa, Latin America
and Canada.
For many years, until a month ago, the ECB, in its
monthly communiqué, warned of a “potential for a disorderly
correction of global imbalances.” That was central bank parlance for a
dollar crash. For what it’s worth, the warning was missing for the
first time in years in this month’s statement.1 Like the boy
who cried wolf, when someone warns about something repeatedly,
few may take that risk seriously anymore. Is it complacency when one drops
the warning?
What many don’t realize is that we don’t
need a low probability / high-risk event – a “black swan”
event – to be concerned. Take the recent turmoil in the Treasury
market: from the high on February 28, 2012 until the close on March 15, 2012,
the U.S. 30 year bond had fallen about 8.5% in value (with declines
continuing as of this writing). Many have previously been chasing yields: a
lot of money had moved into longer dated securities, the so-called long end
of the yield curve. In that process, volatility in that market had come down,
providing the illusion of safety. We don’t need a crash,
we need a return to a more normal environment to have what may be a rude
awakening for investors. The plunge in the 30-year bond in just over 2 weeks
should serve as a wake-up call. It turns out that foreigners appear to have
piled into longer-dated Treasuries just before the recent correction (net long-term TIC flows of $101 billion in January vs. $38.5 billion
expected), possibly making for a few very unhappy, but very important
investors.
What is the relevance for the dollar? Foreign
investors tend to own a large amount of Treasuries. When Treasuries fall in
value, their investments may go down, unless the dollar increases by the same
amount. While some pundits – in an effort to comment on short-term
currency moves on any one day - point out that falling bond prices make the
dollar more attractive as yields are higher, that’s little
consolidation to those already holding Treasuries. Indeed, historically
speaking, our analysis indicates that the U.S. dollar tends to weaken during
early and mid phases of an increasing interest rate
cycle. That’s precisely because the bond market turns into a bear
market in such an environment. It’s in the late phases of a tightening
cycle that foreigners come back to the bond market, in anticipation that the
next bull market for bonds is around the corner; in that phase, the dollar
may get a reprieve.
However, when rates are rising, investors may want
to consider reducing their interest risk, moving from longer dated bond funds
to shorter dated ones. Looking at it from an international perspective, the
same relationship applies; it should not be a surprise that the volatility in
shorter dated fixed income securities is less than that of longer dated ones:
Performance data in the chart above represents past
performance and is no guarantee of future results.
For investors concerned about plunging bond prices,
the obvious move may be to trim interest risk. Some may appreciate the
perceived safety of U.S. dollar cash, although, as our discussion of U.S.
money market funds above has shown, not all cash is equal. Investors
concerned about the purchasing power of the U.S. dollar may want to consider
mitigating the potential risk of a declining dollar by diversifying to other
currencies. Be warned, though, that currency risk is then introduced. A money
market fund will thrive to hold a stable net asset value in U.S. dollar
terms; a currency fund will not. Indeed, much of investing is about trying to
preserve purchasing power. By moving to cash in other currencies, one does
avoid equity risk, and possibly mitigates interest and credit risk. But
risk-free it is not. Indeed, we have argued for a long time that central
banks may be eroding the purchasing power of currencies around the world
– risk free assets can no longer be thought of as such. It was in 2006
when I first said “there is no such thing anymore as a safe asset:
investors may want to consider a diversified approach to something as mundane
as cash.”
Please sign up for our newsletter to be informed as we discuss global dynamics and
their impact on currencies.We
manage the Merk Funds, including the Merk Hard Currency Fund. To learn more about the Funds,
please visit www.merkfunds.com.
1Former
ECB President Willem Duisenberg mentioned "risks pertaining to
external imbalances" in the first time in March 1999. But he didn't reference
it again until 2002. (Instead, he mentioned "there are no major
imbalances in the euro area which would require a longer-term adjustment
process" in 2001.) In May 2002, Duisenberg brought up this topic again
at the press conference, saying "there are still a number of
uncertainties such as those related to ... and to the impact of existing
imbalances elsewhere on the world economy". He used the similar phrasing
in June, October and December 2002 but not every meeting.
It was January 2003 that for the first time
Duisenberg referenced "a disorderly adjustment of global
imbalances" by saying "there are still risks relating to a
disorderly adjustment of the past accumulation of macroeconomic imbalances,
especially outside the euro area." Then he reiterated it a couple of
times during his remaining term as ECB president ended in October 2003. A
note here, current Greek PM and then ECB vice-president Lucas Papademos hosted the September conference in 2003, where
he also referenced "macroeconomic imbalances in some regions of the
world persist."
Since Trichet took
office in November 2003, it became almost a routine to reference
"external/global imbalances" at the press conferences, though his
wording changed over time. During November 2003 and June 2006, Trichet often used the word "persistent global
imbalances" when talking about concerns and risks to growth. Then he
referenced "a disorderly unwinding of global imbalances" for the
first time in August 2006. He frequently used "possible disorderly
developments owing to global imbalances" during 2007-2008 and
"adverse developments in the world economy stemming from a disorderly
correction of global imbalances" in 2009, and started to regularly
reference "concerns remain relating to … and the possibility of a
disorderly correction of global imbalances" since September 2009,
through his last press conference in October 2011. During his eight years in
office, the only times he didn't mention "global imbalance" at all
were August 2007, April 2005, and from October 2004 to January 2005.
Draghi continued the tradition of referencing "the
possibility of a disorderly correction of global imbalances" in all of
his press conferences from November 2011 to February this year. The past
meeting in March was the first time he didn't reference it.
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