The relative strength of the US dollar is one of the great mysteries of the financial world. It has defied predictions of collapse for years, despite copping severe abuse from its managers, the US Treasury and their henchman at the Federal Reserve.
But the question is, collapse against what? Other, similarly mismanaged currencies? You see, the problem for the US dollar bears is that there are no other asset markets large enough to absorb the huge flow of international capital.
Capital doesn’t reside in currencies. It resides in assets denominated in currencies. With US capital markets being the largest in the world, the reality is that capital will flow through the US dollar and into US dollar denominated assets until there is relative value elsewhere to draw it back out.
However, the problem with this analysis is that there is increasing evidence that international capital is beginning to shun US denominated assets. Data out overnight supports this view. Treasury International Capital (TIC) data tracks the flow of capital in and out of US dollar denominated assets, both short and long term.
The recent trend of these flows is alarming, and last night’s data confirms the trend. As we’ve argued previously, it’s this trend that is driving the Fed’s policy of continuing QE. All the talk about employment and economic growth is merely cover.
So what is this trend?
It is the lack of foreign capital flowing into the US. In particular, there is a lack of foreign appetite for US Treasury bonds. In the 12 months to September 2013, the private and official sectors combined purchased just US$73.5 billion in US Treasury bonds and notes. The ‘official’ sector, which represents foreign central banks, purchased a net amount of just US$7 billion.
Compare this to the current year’s fiscal deficit of around US$650-700 billion, which is newly created debt that must be financed by someone. That’s why the Fed must continue with QE. The US is a net consumer. It doesn’t have the financial resources to finance its own deficits. It needs foreign capital to do this. When foreign capital doesn’t cooperate, the Fed must step in.
For the year to September, foreign investors dumped US$195 billion in long term assets. Compare that to the 12 months to September 2012, where foreigners made net purchases of US$380 billion. That’s quite a turnaround.
But the lack of foreign demand is not just restricted to long term assets. In the 12 months to September, foreigners reduced their holdings of short term assets (duration of one year or less) by $60 billion.
So if foreigners are selling short and long term US dollar denominated assets, and the Fed is effectively the buyer of last resort for US Treasury bonds, then what is holding up the US dollar?
It’s a good question. As far as we can tell from the data, it appears as though foreigners are not completely dumping the dollar. But they’re not far off it.
In the 12 months to September, the ‘change in banks’ own net-dollar denominated liabilities‘ increased by a whopping US$380 billion, more than offsetting the outflows from other assets.
In other words, foreigners are moving into cash…the most liquid asset form and the easiest to sell if you need to get out of the dollar in a hurry.
So putting it all together, you’re seeing foreigners sell off long and short term US denominated assets and parking it all in cash. On the other hand, the Fed is buying up US$85 billion per month in US Treasuries and mortgage backed securities (US$1 trillion annually) with cash created from their ‘conjuring account’.
This cash creation is more than enough to cover foreign selling. And with foreigners parking the proceeds of their sales in cash (created by the Fed) the dollar stays strong…for now anyway. (Exhale…)
But the data for the month of September wasn’t encouraging. Foreign holdings of cash fell by US$90.7 billion during the month, and total foreign outflows amounted to US$106 billion. Perhaps fears of tapering accelerated foreign selling during September.
Whatever the reason, it’s not a good sign. Especially given the fact that the US is still in excess consumption mode (that is, it is not saving at all and remains entirely dependent on the Fed and foreigners to finance its deficits).
In fact, in the month of September the US ran a record US$30.5 billion trade deficit with China. How does the US pay for this deficit? By issuing Treasury bonds! As it turns out, China bought US$25.7 billion in bonds in September…accepting US paper in exchange for their sweat and hard work.
China also bought nearly 110 tonnes of gold in September, so they are trying to hedge their huge paper position. On the surface this strategy isn’t working. The ‘price of gold’ continues to fall, down about US$15 dollars per ounce in last night’s trade. That’s despite the bearish dollar news.
We’ve discussed many times before how the ‘price of gold’ is not really determined by physical demand. Rather it’s determined by traders of gold derivatives or paper claims on physical gold. Right now, those traders (the speculating hedge funds) are positioned short and look set on driving prices lower.
If you’re holding gold what do you do? If your time frame is three months, you may want to get out. If it’s a year or more, this may be another buying opportunity. We had the opportunity to chat with Gold Anti-Trust Action Committee Secretary Chris Powell a few weeks ago. To find out his insights into the evolution of the gold market, you can view a recording of the interview here.
In short, if you’re focussed on just the major global stock indices, you’re probably thinking everything is OK. But under the surface there are some treacherous currents forming. This will get interesting as we head into 2014.
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