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Ship of fools: CBs sailing headlong into 2009 currency crisisSteven Lachance The collapse of the US-centric global credit bubble caused what is now labeled a financial crisis in 2008. At heart, this process amounts to a necessary rebalancing of economic and financial market distortions that had built up over many years, the gargantuan US trade deficit being the most obvious and problematic manifestation of an untenable situation. Clearly, a cleansing of excesses was called for and, in the long run, rebalancing should be beneficial despite the short-term pain. Short-term pain, however, is evidently anathema to politicians and their captive central bankers. Their efforts to prevent rebalancing in the name of economic and financial market stability are laying the groundwork for a far more devastating crisis. The world would go on with a 50% drop in share prices and real estate values, some major bank failures, and 5,000 fewer hedge funds. A doubling of unemployment and several years of recession could be endured, even if the pain to those directly affected seems insurmountable. The degree of suffering, though, will be many degrees worse in the event of a global collapse of paper money, which policymakers are inviting as early as the first half of 2009 with their current actions. The modern central bank is all-powerful, but it only has power to do one thing: destroy its own currency. As long as a currency retains some confidence and some value, an economy and financial system have the potential to heal over time. All is lost if the currency, which is both the medium of exchange and the unit of measure for the value of all economic transactions, fails as a result of mismanagement by its issuer. The implementation of a zero-interest-rate-policy (ZIRP) and quantitative easing by the central bank of a debtor state with little or no domestic savings is the single most irresponsible and dangerous course available, and the FED has embarked on precisely this strategy at a time when the bubble in US Treasuries has reached the blow-off stage. Japan tried ZIRP and the yen lived to tell about it. The dollar, however, won't be so fortunate and here is why. There is the equivalent of over $7 trillion deposited in savings accounts in Japan, almost half of which is in the government-owned post office. Without having to even ask, the Japanese government could use this money to buy government bonds. It was enough to cover nearly all of the deficit spending since the collapse of the bubble economy in 1990. No borrowing from foreigners and very little printing of new currency by the Bank of Japan to buy the newly issued government bonds. The US has long had a negative savings rate. It's newly issued government bonds, for the War on Terror or for pork barrel politicking, have been bought by foreigners, mostly Asian central banks with too many dollars accumulated from trade surpluses with the US. With trade surpluses falling and financing needs at home rising, these Asian central banks are less able or eager to buy Treasuries. In 2009, the US Federal government will run a deficit of at least $1 trillion, perhaps even $2 trillion. Who will buy these bonds? There are no domestic savings and the Asian central banks, read vendor financers, are balking. At last its the FED's turn, and this will prove to be its turn to fail. The FED will print dollars, which today means creating electronic entries in its balance sheet, to buy Mr. Obama's bonds. The bond market knows this, partly because Ben Bernanke has gone out of his way to say so, and is front-running the buying of Treasuries in the hope of passing them off to the FED at a later date for a profit. A bubble of colossal proportions has developed so that Treasury yields are now as low as at the depth of the Great Depression, when the principal of the bonds was effectively guaranteed against the loss of purchasing power with a fixed exchange rate for the dollar against gold. As more and more new bonds come down the issuer's pipe, the FED will have to steadily increase its purchases with newly printed currency (electronic ledger entries). The bond arbitrageurs front-running the anticipated price increases follow a herd instinct, when one blinks in the face of the blizzard of currency creation, they will all panic and sell, resulting in a mirror image of the currently parabolic rise in bond prices. This reversal now appears imminent, with the probability of the parabolic spike in Treasuries surviving the first quarter of 2009 minimal. It is often said that the value of a dollar depends on confidence alone. Actually, it depends on the bond market. The purchasing power of Treasuries and the purchasing power of the dollar are essentially one and the same. The end of the great US government bond bubble is the coup de grâce for the dollar. The FED may have been able to avoid this, or at least delay it, if its priority had been on protecting the underpinnings of the Treasury market, which is the only mission it can hope to accomplish, instead of destroying its own balance sheet in a vain attempt to prevent an inevitable, necessary, and ultimately healthy rebalancing of the American and the global economies. With ZIRP and quantitative easing (monetization), the FED has cast its die. The outcome should not be in doubt any longer: after the credit bubble collapse and a relatively brief period of deflation in 2008, the actions of the FED and other central banks around the world will undermine sovereign bond markets, which are poised for collapse in 2009. The two most important prices in the world of finance are the price of US government debt and the price of gold. The two are inversely correlated, but the price of gold tends to lead price changes in Treasuries. Gold appears to have bottomed in November 2008, suggesting a future topping out of Treasury prices. The gold price rise should accelerate as the Treasury bubble begins to collapse. These are the two sides of the same coin for what will be the most important story in finance in the coming year. Buy gold, sell Treasuries; sooner rather than later. Steven Lachance Steven Lachance is a financial translator based in Tokyo. Over the last decade, he has worked for major European and Japanese investment banks, including Deutsche Bank Group, Commerzbank, Nikko Solomon Smith Barney, and Mizuho Securities.
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