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Will China lead a Stampede out of the US Dollar?By Gary Dorsch The $2 trillion per day foreign exchange market never sleeps. Yet for the past six months, the big-3 central banks, the Federal Reserve, the European Central Bank, and the Bank of Japan managed to lull the currency markets into a deep trance. Since last May, the big-3 central banks corralled the US dollar to within a 3% to 5% trading range against the British pound, the Euro and Japanese yen. The big-3 central banks utilized their three major weapons, (1) relentless jawboning, (2) Japanese threats of intervention, and (3) coordinated rate hikes, telegraphed far in advance to avoid any nasty surprises in the markets. But the big-3's spell-binding magic act began to wind down on November 25th, when Chinese deputy central banker Wu Xialong jolted the foreign currency markets, warning other Asian central bankers of the future risk of a US dollar devaluation. Beijing is having second thoughts about the composition of its $1 trillion portfolio of FX reserves, with 70% held in low yielding US fixed income securities. "Firstly, long-term US interest rates are falling. Secondly, the exchange rate of the US dollar, which is the major reserve currency, is going lower, increasing the depreciation risk for east Asian reserve assets," Wu said. On October 10th, Fan Gang, another member of People's Bank of China's policy committee, made similar comments, "China risks an erosion of its holdings because the US dollar will probably decline." On August 29th, Gang wrote, "The US dollar is no longer a stable anchor in the global financial system, nor is it likely to become one, therefore it is time to look for alternatives."  Central banks are key players in the currency markets, and traders are always on the lookout for signals that the heavy hitters are diversifying their FX reserves away from the world's reserve currency, the US dollar. Global central bank reserves have more than doubled to $4.9 trillion in just three years, with particular focus on the massive US dollar stockpiles built up by Asian central banks, which could be switched into other currencies such as the Euro, Japanese yen, British pound, or Gold. China's FX reserves are on track to hit $1.5 trillion in the second quarter of 2008, and might hit $2 trillion by the end of 2010. China's holdings of US Treasuries have skyrocketed from $59.5 billion to $342 billion since January 2001, and have kept interest rates artificially low in the face of large federal budget deficits. So the slightest hint of a bearish Chinese disposition towards the US dollar instantly sent the Euro spiraling above the psychological $1.30 level last week. US Democrats on the Joint Economic Committee argued on Nov 4th, that "the United States must reduce its heavy dependence on foreign borrowing in order to avoid a run on the dollar and a steep rise in interest rates. Even without a run on the dollar, the need to pay interest of $100 billion or more per year on foreign holdings of Treasury securities will reduce US national income." "Our reliance on China and other nations to finance our debt is the result of a deliberate policy by the Bush administration, one that reversed course from the Clinton administration, and has favored deficit financing of tax cuts and federal spending over a prudent fiscal policy. It will take years of sound fiscal policy to reduce our reliance on foreign lenders and return the federal debt to a prudent level," the Congressional Democrats concluded.  The Bush administration grants Beijing free and unfettered access to US consumer markets, in return for massive Chinese purchases of US bonds. But since Beijing decoupled the yuan from the rigid peg of 8.27 /US$, the yuan has appreciated by 5.6% to 7.835 per US dollar. That's translated into a 10% loss for Beijing's holdings of 10-year US Treasury notes when converted back into Chinese yuan. During the same time, the price of Gold gained 40% against the Chinese yuan. "We have had a very clear diversification plan," said Chinese central bank chief Zhou Xiaochuan on Nov 9th. "We are considering lots of instruments for diversification, including currencies, investment instruments, and emerging markets." Asked if diversification included gold, Zhou coyly replied, "That's a separate thing." Forward traders in Hong Kong predict the dollar will fall another 4% to 7.53 yuan within the next 12-months. US Treasury chief Henry Paulson and Federal Reserve chief Ben Bernanke will meet with Chinese officials on Dec 14-15th in Beijing. The yuan had its largest monthly gain in September, when Paulson held talks in Beijing with President Hu Jintao and Premier Wen Jiabao. "There has been a fair amount of tension in the economic relationship,'" said Paulson at a business conference in London on Nov 27th. "For this to be successful, issues such as greater currency flexibility must be addressed," he said. Ahead of the December meeting, traders think Beijing might allow the dollar to fall 0.5% to 7.80 yuan, to equal the Hong Kong dollar's peg against the US dollar. Korean Experience with US T-Notes Interestingly enough, the December 14th meeting in Beijing would be exactly one year since PBoC chief economist Yu Yongding called for East Asian central banks to come up with a plan to slow the rate of accumulation of US dollars and eventually cut their holdings. "Asian countries don't need more than $2 trillion of foreign exchange reserves, and dangerously exposed to a decline in the dollar." Yu said China faced big losses on its reserves if the US dollar does decline by as much as 30 percent. "That is a very big problem and I think the Chinese government should take some action to reduce the growth rate of the accumulation of foreign exchange reserves as we're still facing the possibility of a big devaluation of the US dollar, so capital loss will be huge," Yu warned. "China's economy would take a big hit if the US dollar weakened sharply due to such factors as a bursting of the US property bubble. The loss for China's foreign exchange reserves would be extremely serious. If that happens, it will be a tremendous hit to the Chinese economy," he said. Yet Chinese leaders were slow to accept Yu's advice and didn't see the light until a few weeks ago.  China faces a much graver situation than the Bank of Korea, which abandoned its defense of the US dollar at 1140-won two years ago. In Korean won terms, US Treasury 10-year notes have since plunged 22% lower, with the dollar falling to 930-won. Soon after the dollar collapsed from 1140-won towards the psychological 1000-won level in February 2005, the BoK said it would not sell US bonds outright, but instead, would diversify future reserve accumulation into high yielding currencies such as Australian and Canadian dollars, and the British pound. Yet despite the Korean won's 20% appreciation against the US$ from two years ago, Korean exports hit a record $30 billion in September '06, or 22% higher than a year earlier. In the first nine months of 2006, Korean exports gained 14.9% year-on-year to US$238.62 billion. Bilateral trade between China and Korea was $61.9 billion last year, up 24% from the previous year, as Seoul started to wean itself off the US market. Needless to say, traders will closely scrutinize the monthly reports on foreign purchases of US Treasury securities, to see if China is shying away from the depreciating US dollar, and instead, following the example of the Bank of Korea. That might account for the urgency of next month's meeting in Beijing, especially with Democrats preparing a protectionist plan in Congress. Underpinnings of US dollar remain weak After the 3-year bear market for the US Dollar Index, which shaved a third of its value by December 2004, there was cautious optimism among FX traders that the greenback had finally bottomed out. In 2005, the US dollar began a counter-trend rally, recovering a third of its 2002-04 losses, under a wave of slow but steady rate hikes by the Federal Reserve to as high as 5.25 percent. Yet despite the Fed's best efforts to rescue the dollar, the underpinnings of the US currency stayed weak. Since December 2001, the monthly US trade deficit has increased $37.7 billion, saddling its economy with huge foreign debts and taxing domestic growth. In the third quarter, the trade deficit subtracted 0.6% from GDP growth. American economic output would be 20% greater today, were it not for the trade deficits accumulated over the past twenty years. Despite the sharp devaluation of the US$ Index, the US trade deficit hit a record high of $69 billion in August. Three major segments account for the 90% of the US trade deficit Energy, automobiles, and Chinese and Japanese imports. On Nov 14th, General Motors CEO Rick Wagoner said Detroit automakers share a "strong conviction that the Japanese yen is systematically undervalued, which helps them to maintain significant trade balance surpluses in our industry." Diplomatic efforts to persuade China to stop manipulating the yuan for the past 5-years were a sham.  Energy imports have increased $17.1 billion per month since 2001, with the average price of imported oil soaring from $15.46 to $62.52 per barrel, and monthly imports increased 352 to 414 million barrels. Automobiles and parts account for $10.7 billion of the monthly trade deficit. Japanese and Korean manufacturers have snatched market share from GM and Ford by offering more attractive and reliable vehicles. The US trade deficit with China was $23.0 billion in October, and has increased $17.5 billion per month since December 2001. Imports from China increased to a record $27.6 billion in September, but US exports to the Asian nation fell to $4.6 billion. China will soon replace Mexico as America's second-largest trading partner behind Canada. So far this year, the value of trade between China and the US is $246.7 billion. That compares with $248.3 billion in trade with Mexico. Interest rate differentials undermining US dollar Making matters worse for the US dollar is a sharp drop in interest rate differentials with Euro yields, one of the key factors propping up the dollar for the past two years. The gap between US Treasury's 2-year Note and the German 2-year note is near an 18 month low, hovering at 108 basis points this week, and down from 180 basis points in mid June, just before the Fed's last rate hike to 5.25%.  While the US Treasury bond market is pricing in a Fed rate cut, the benchmark German bund market is pricing in future ECB rate hikes. Yet it is interesting to note, the US dollar's interest rare advantage was shrinking from a high of 180 bp in mid-June to as low as 102 bp on October 4th, but the Euro was pinned near $1.25 in mid-October, acting oblivious to the big shift in interest rate differentials. Ironically, the Euro bottomed at $1.25 on October 17th, when the US Treasury reported that the foreign demand for US bonds and stocks soared to a record $116 billion in August, compared to only $32.9 billion in July. Thus, the US dollar topped out a very bullish news, then headed south over the next five weeks, as the arcane foreign exchange market decided to look at shrinking interest rate differentials. Arab Oil kingdoms suffer FX losses on US$ Bonds The foreign exchange market was also guided by statements from former Fed chief "Easy" Al Greenspan, who indicated on October 26th, "We're beginning to see some move from the dollar to the Euro, both from the private sector and from monetary authorities and central banks. We'll get to the point at some point that willingness to finance the current account deficit will slow," Greenspan warned. Greenspan was proven correct on Nov 16th, when the US Treasury said foreigners had scaled down their purchases of US bonds and stocks by 45% in September to $53.7 billion, falling short of the $64.4 billion US trade deficit for that month. Japanese bond traders were net sellers of $5.1 billion of US Treasuries, but Beijing was a net buyer of $3 billion and allowed the dollar to fall 1.5% to 7.84 yuan.  Arab oil kingdoms were net buyers of as much as $6.9 billion thru their brokers in London in September, after adding $11.1 billion to their portfolios in August. Arab oil kingdoms are recycling part of their petrodollar surplus into US Treasury bonds, to help finance the American war effort in Iraq, which costs about $2 billion per week. But the British pound has been a stronger currency than the Euro against the US dollar recently, dealing a bigger blow to Arab holdings of US bonds. European Central Bank Signals higher rates ahead The ECB had already raised its key repo lending rate by 125 basis points since last December and has telegraphed a further 25 bps increase to 3.5% for December 7th. When asked asked about the rate outlook beyond that, Greek central banker Nicholas Garganas said on Nov 7th, "No matter what criteria one uses to characterize monetary conditions, the conclusion is inescapable that there is more than ample liquidity. Despite the interest rate increases to date, real rates remain through the whole maturity spectrum near historically low levels," he said.  "There is little doubt to have further withdrawal of monetary accommodation. Moreover inflationary risks remain on the upside. If one looks at what is happening to producer prices, and non-energy related prices, the picture is one of elevated prices for goods. I think this is a clear indication of significant inflationary pressures remaining in the system," Garangas said. The Euro zone's M3 money supply expanded at an annualized rate of 8.5% in October for the second month in a row, far above the ECB's original 4.5% target. While total Euro zone bank lending growth eased 0.2% to 11.2% in October, loans to the corporate sector hit 12.9% annual growth rate in October, the highest since records began in 1998. Loans have increased in size, largely due to massive borrowing to finance $1.3 trillion of European mergers and acquisitions this year.  Futures traders in Frankfurt predict the ECB is on course to raise its repo rate by a quarter-point in the first quarter of 2007 to 3.75%. Meanwhile, traders in Chicago are betting on a 50% chance of a quarter-point Federal Reserve rate cut to 5.00 percent. That would narrow the US$'s rate advantage by 50 basis points and buoy the Euro above $1.300. However, due to the dollar's structural weakness, any round of Fed rate cuts would be limited, so as to avoid a dollar free-fall into the abyss. Bank of Japan battles Tokyo warlords over Interest rates G-10 central bankers are calling on the Bank of Japan (BoJ) to tighten its monetary policy further, to discourage carry traders from borrowing yen, and reinvesting the funds in inflation assets around the world. European bankers object to unilateral ECB rate hikes without similar moves by the BoJ, which could exert further upward pressure on the Euro beyond 150-yen, already at 8-year highs. The BOJ has left monetary policy unchanged after hiking its key overnight call rate target to 0.25% in July, the first rate hike in six years. Japan's economy grew an annualized 2.0% in the July-September quarter, double the pace the market was expecting and higher than the 1.6% growth in the United States in the same quarter. "I told the G-20 that the Japanese economy continues to expand steadily, amid stable prices. If this trend continues, we will adjust monetary policy gradually, looking at various risk factors ahead," said BoJ chief Fukui.  Japan's monetary base in October was down 21.3% from a year earlier, marking the eighth consecutive month of decline. The monetary base has been falling on a year-on-year basis since March after the BOJ announced the end of its policy of flooding the banking system an excess of 26-trillion yen on March 9th. But despite the BoJ's historic draining operation, the Japanese overnight loan rate remains at a paltry 0.25%, hardly reflective of the size of the world's second largest economy. Still, a top Japanese ruling party politician on Nov 7th, opposed a credit tightening by the BoJ, saying the economy had not yet emerged from deflation. "I believe Japan has yet to come out of deflation," said Shoichi Nakagawa, the ruling Liberal Democratic Party policy chief. "I'm against the BOJ raising rates. Given the state of the Japanese economy, talking of a rate hike is absurd," he said.  Tokyo financial warlords are closely watching the Bank of Japan, because a tighter monetary policy might cause, "Increases in long-term rates, which would have a big effect on the country's fiscal situation through the government's debt interest payments," said Japanese PM Shinzo Abe on October 4th. "We have to keep a close watch on their moves." A 1% increase in 10-year bond yields would push up the debt-servicing costs by 1.6 trillion yen ($13.6 billion). Debt-servicing costs already account for a quarter of spending in the annual budget. Japan had 765 trillion yen in sovereign marketable securities, or $6.5 trillion, outstanding at the end of June 2006, compared with $4.3 trillion in the US Treasury market. Since then, the spread between the US 10-year yield and the Japanese 10-year yield has narrowed 54 basis points to 2.82%, making US bonds less attractive to Japanese investors, and weighing on the dollar /yen. Is "Stagflation" on the horizon for US Economy? In the months ahead, the Federal Reserve could face the dreaded nightmare of "Stagflation." Weaker home prices and a sinking US dollar on one hand, and rising gold prices on the other hand. Fed chief Bernanke observed on Nov 27th, "In the case of inflation, the risks to the forecast seem primarily to the upside. A failure of inflation to moderate as expected would be especially troublesome." The December 1st edition of Global Money Trends will present forecasts for the US dollar against an array of different currencies, and the impact of a weaker dollar for global stock markets, interest rates, gold, silver, base metals, key commodities such as crude oil and grains, and commodity indexes. ** To "Stay on Top of Volatile Markets", consider a subscription to the Global Money Trends newsletter published around the 1st and 15th of each month in pdf format, and 20-25 pages in length. GMT collects a wide array of news and information from reputable sources, filters out the noise and distractions, and puts all the pieces of global economic puzzle together into coherent snapshot analyses, with lots of cool charts depicting the inter-relationships of markets and economies around the world. Here's what you will receive with a subscription, Insightful analysis and predictions of, (1) top stock market indexes around the world, and US-listed Exchange Traded Funds (ETF's) and closed-end country funds. (2) Commodities such as crude oil, copper, gold, silver, the CRB index, and gold mining and oil company indexes. (3) Foreign currencies such as, the Australian dollar, British pound, Euro, Japanese yen, and Canadian dollar. (4) Libor interest rates, global bond markets and their central bank monetary policies. Subscribers will also receive Email Alerts, sent out in-between regular newsletter postings, when important information unfolds in the global markets. A subscription to Global Money Trends is $125 US dollars per year for 24 issues, including access to all back issues. Click on the following hyperlink, to order now, http://www.sirchartsalot.com/newsletters.php Gary Dorsch 321gold |
