The Jubilee

  • A Krainer
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  • August 2009
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US debt dumping: sign of panic or an act of war?

Posted by Alex Krainer on August 31, 2009

Although the US economy is now showing definite symptoms of deflation, the risk of a rapid decline in the US dollar, a rise in interest rates and high inflation remain considerable. To address these risks, investors should allocate a portion of their assets to funds trading financial and commodity futures which stand to benefit from major price dislocations in the future.

Perhaps the most pressing dilemma regarding the current economic crisis is whether it will lead to deflation or inflation.

At least as far as it concerns the US, the world’s largest economy the answers have emerged over the past several months, beginning with the publication in June of the Federal Reserve’s Flow of Funds Report for Q1 2009. The Fed’s report clearly showed that in spite of the flooding of massive stimulus funds and the Fed’s zero interest rate policy (ZIRP) initiated in December 2009, the economy underwent the worst credit collapse on record. The report further shows that US households suffered the worst loss of wealth of all time (for a full analysis, visit Dr. Martin Weiss blog here). Meanwhile, the average US household is about $110,000 in debt.

Compounding this adversity is the dismal US labor market. Only by way of the Labor Department’s gimmicks could the economy’s loss of 247,000 jobs in July actually result in a reduction of unemployment from 9.5% to 9.4%. The gimmicks consist of a sequence of changes in how labor market statistics are collated and interpreted. For example, if the Labor Department today used the same methods as in 1980, unemployment would stand at over 20%. In fact, the Department’s broad measure of unemployment, which includes the category of discouraged workers which is politely ignored by the media, is now close to that figure.

For an economy where consumer spending comprises over 70% of GDP, these conditions are severely depressing consumer demand. To stimulate sales, businesses are forced to cut prices and profit margins, generating significant deflationary pressures.

Do not rule out inflation yet

In spite of all this, the risk of high inflation or even hyperinflation cannot be dismissed. This is due to the activities of the US government and its increasingly heavy reliance on debt to cover its budget deficits. The most recent budget figures show that tax revenues cover less than 55% of government expenditure. Increasing taxation could push an already weak economy deeper into depression, so the issuing of further debt is the only alternative (apart from the unthinkable: cutting expenditures). However, as the US government’s demand for credit exploded, its perceived creditworthiness took a nosedive last year with the government takeover of Fannie Mae and Freddie Mac. This act alone doubled the US national debt by adding $5.3 trillion in mortgages and derivatives that are known to be fraudulent.

Capital markets are never this forgiving and the demand for US debt fell appreciably leaving the US Treasury with no option but to turn to the printing presses and monetize its debts. This became apparent after the Fed auction of the 7-year Treasury notes on August 5th this year. Essentially, the Federal Reserve made up the shortfall in demand for the Government’s T-Notes by purchasing 47% of the issue for its own balance sheet (as brilliantly exposed by Chris Martenson – see here and here).

The risk that the Fed’s purchases of US debt will eventually be monetized is sowing anxiety among US foreign creditors who hold between $4 and $5 trillion in US dollar assets. China, with some $2 trillion in USD assets has now sharply curtailed further purchases of US treasuries and is attempting to reduce its hoard of US dollars by purchasing natural resources and strategic assets around the world. In June, China reduced its holdings of US treasuries by $25 billion – the most China has ever sold in a single month. The significance of this small reduction is in how it affects the mood of other holders of US assets.

US debt dumping: creditor panic or act of war?

A bizarre event that took place this summer might shed some light on that mood. Namely, in June, two Japanese nationals were detained by Italy’s financial police at the Chiasso border crossing with Switzerland carrying $134.5 billion worth of US Bonds (yes, billion with a B – see reports here and here). The story attracted little attention outside Italy and we don’t know what subsequent investigations may have uncovered. Although the US Treasury claimed that the bonds were “clearly fakes,” one has to wonder who would fake $134 billion worth of US debt, and to whom they might hope to sell it.

Either way, there is no reason to dismiss this story. If the bonds were authentic, they suggest that some countries are trying to rid themselves of US debt underneath the financial market radars. If the bonds were forgeries, they suggest that someone may be attempting to provoke a collapse in the value of US dollar assets (counterfeiting of currency and sovereign debt securities is a common tactic of warfare aimed at destabilizing the economies of rival powers). Either possibility should raise a red flag, foreshadowing the danger of a future stampede out of US dollar holdings and the collapse of the currency.

Future risks and opportunities

In spite of the deflationary pressures gripping the domestic US economy, the reality is that the US government heavily depends on global capital markets where the value of its currency and interest on its debt will ultimately be decided.

For investors, this situation represents a risk as well as an opportunity. In the near future, we could see one or all of the following outcomes unfold: a further decline in the US dollar against other currencies, an increase in interest rate with the corresponding drop in the value of treasury instruments, and a continued rise in commodity prices, especially in energy markets, precious and industrial metals, and certain agricultural commodities. How these events might affect equity markets is not easy to predict. In normal circumstances, inflation and rising interest rates tend to depress the value of equities, but with very high levels of inflation, equity markets could continue rising. We recently saw the case of Zimbabwe whose stock market was among the world’s top performers while the country’s economy suffered extreme inflation.

I believe that the best way to gain favourable exposure to these markets is by allocating a portion of investable assets to hedge funds specialized in financial and commodity futures.


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