Phisix: Don’t Ignore the Bond Vigilantes

A human group transforms itself into a crowd when it suddenly responds to a suggestion rather than to reasoning, to an image rather than an idea, to an affirmation rather than to proof, to the repetition of a phrase rather than to arguments, to prestige rather than to competence.” Jean-François Revel French Journalist and Philosopher

This is one chart which every stock market bulls have either ignored or dismissed as irrelevant.

Yields of 10-year US Treasury Notes skyrocketed by 249 basis points or 9.7% this week to reach a TWO year high of 2.829% as of Friday’s close. This represents 803 basis points above the May 22^nd levels at 2.026%, when the perceived “taper” talk by US Federal Reserve chief Ben Bernanke jolted and brought many of global stock markets down on their knees.

While US markets, as embodied by the S&P 500 (SPX), recovered from the early losses to even carve milestone record highs, ASEAN markets (ASEA-FTSE ASEAN 40 ETF) and ASIAN markets ($P1DOW-Dow Jones Asia Pacific) posted unimpressive gains. Such failure to rise along with US stocks has revealed her vulnerability to such transitional phase, see red vertical line. 

Considering what I have been calling as the Wile E. Coyete moment or the incompatibility or the unsustainable relationship between rising stock markets and ascendant bond yields (including $100 oil), it seems that signs of such strains has become evident in US stocks.

As I previously wrote[1],

The stock markets operates on a Wile E. Coyote moment. These forces are incompatible and serves as major headwinds to the stock markets. Such relationship eventually will become unglued. Either bond yields and oil prices will have to fall to sustain rising stocks, or stock markets will have to reflect on the new reality brought about by higher interest rates (and oil prices), or that all three will have to adjust accordingly...hopefully in an 'orderly' fashion. Well, the other possibility from 'orderly' is disorderly or instability.

The S&P fell 2.1% this week adding to last week’s loss as yields of 10 year USTs soared (see green circle).

Rising yields affect credit markets anchored on them. This means higher interest rates for many bond or fixed income markets and fixed mortgages[2]. 

And given a system built on huge debt, viz, $55.3 trillion in total outstanding debt and $179 trillion in credit derivatives, rising interest rates will mean higher cost of debt servicing on $243 trillion of debt related securities[3], thereby putting pressure on profit margins and increasing cost of capital which magnifies credit and counterparty risks. Higher rates also discourage credit based consumption, thereby reducing demand. 

In essence, ascendant yields or higher interest rates will expose on the many misallocated capital brought about by the previous easy money policies.

One example is margin debt on stock markets.

The recent record highs reached by the US stock markets have been bolstered by inflationary credit via record levels of net margin debt (New York Stock Exchange).

Should rising yields translate to higher interest rates and where market returns will be insufficient to finance the rising costs of margin credit, then this will lead to calls by brokerage firms on leveraged clients to raise capital or collateral (margin calls[4]) or be faced with forced liquidations.

And intensification of the offloading of securities due to margin calls may become a horrendous reflexive debt liquidation-falling prices feedback loop.

Since 1950s, record margin debt levels tend to peak ahead of the US stock market according to a study by Deutsche Bank as presented by the Zero Hedge[5]. 

In 2000 and in 2007, the aftermath of record debt levels along with landmark stock market prices has been the dreaded debt-stock market deflation spiral or the stock market bubble bust.

Net margin debt appears to have peaked in April according to the data from New York Stock Exchange[6]. This is about 3 months ahead of the late July highs reached by the S&P 500 echoing the 2007 cycle.

But will this time be different?

Rising Yields Equals Mounting Losses on Global Financial Markets

Rising yields extrapolates to mounting losses on myriad fixed income instruments held by banks, by financial institutions and by governments. 

For instance, bond market losses exhibited by rising yields on various US Treasury instruments has led to record outflows in June, which according to Reuters represents the largest since August 2007[7].

The largest UST holder, the Chinese government and her private financial institutions, who supported the UST last May[8], apparently changed their minds. They sold $21.5 billion in June. 

Meanwhile the second largest UST holder, the Japanese government and her financial institutions unloaded $20.3 billion signifying a third consecutive month of decline.

Combined selling by China and Japan accounted for 74% of overall net foreign selling.

Total foreign holdings of UST fell by $56.5 billion or by 1% to $5.6 trillion in June where about 71% of the total UST foreign holdings represent official creditors[9]

The Philippines joined the bond market exodus by lowering her UST holding by $1.9 billion to $37.1 billion in July.

However, Japanese investors, mostly from the banking sector, reportedly reversed course and bought $16 billion of US treasuries during the first week of August[10].

Instead of investing locally, as expected from the audacious policy program set by PM Shinzo Abe called Abenomics, the result, so far and as predicted[11], has been the opposite: capital flight. The lower than expected GDP in June also exposes on the continuing reluctance by Japanese investors to invest locally (-.1%)[12].

Politicians and their apologists hardly understand that policy or regime uncertainty and price instability obscures the entrepreneurs’ and of business peoples’ economic calculation process thereby deterring incentives to invest. When uncertainty reigns, especially from increased interventions, people opt to hold cash. And when government debases the currency, people will look to preserve their savings via alternative currencies or assets.

This only shows how the average Japanese investors have been caught between the proverbial devil and the deep blue sea.

It’s not just in UST markets. Losses have spread to cover many bond markets

In the US, bond market losses led to redemptions on bond funds as investors yanked $68 billion in June and $8 billion in July. The Wall Street Journal[13] reports that the June outflow signifies as the first monthly net outflow in two years, according to the Morningstar

Again the actions of the bond vigilantes are being reflected by the reflexive feedback loop between falling prices (higher yields) prompting for liquidations and vice versa.

Rising yields will not only translate to higher cost of capital, which reduces investments, and diminished appetite for speculation, the sustained rate of sharp increases in bond yields accentuate the “the uncertainty factor” in the financial and economic environment. Outsized volatility from today’s mercurial bond markets compounds on the uncertainty factor by spurring a bandwagon effect from the reflexive selling action and in the reluctance by investors to increase exposure on risk assets.

As bond yields continue to rise the losses will spread.

The Impact of Rising UST Yields on Asia

US Treasuries have been also used as key benchmark by many foreign markets. Hence, rapid changes in US bond prices or yields will likewise impact foreign markets.

And as explained last week, substantial improvements in the US twin (fiscal and trade) deficits postulates to the Triffin Paradox. This reserve currency dilemma implies that improved trade and fiscal balance means that there will be lesser US dollars available to the global financial system which has been heavily dependent on the US dollar as bank reserve currency and as medium for trading and settlement. 

Such scarcity of the US dollar may undermine trade and the the reserve currency recycling process between the US and her trading partners.

Higher yields and a rise in the US dollar relative to her non-reserve currency major trading partners are likely symptoms from a less liquid or a dollar scarce system

And if rising UST yields have indeed been reflecting on growing scarcity of the quantity of US dollar relative to her non-reserve currency trading partners such as ASEAN, then higher yields would likewise imply pressure on the currencies, and similarly but not contemporaneous, on prices of financial assets.

All four currencies of ASEAN majors are under duress from the bond vigilantes.

The pressure on prices of other financial assets will be a function of accrued internal imbalances that will be amplified by external concerns.

One exception is the Chinese yuan whose currency has yet to be adapted as international currency reserve. The yuan trades at record highs vis-à-vis the US dollar, even as her 10 year yields have been on the rise[14].

In the meantime, fresh reports indicate that despite all the previous regulatory clamps applied by the Chinese government, China’s bubble has been intensifying with new home sales rising in 69 out of 70 cities in July, and with record gains posted by the biggest metropolitan cities[15].

Curiously the report also says that the China’s property markets expect minimal intervention from the Chinese government.

If true then this means that in order for the Chinese economy to register statistical growth, the seemingly desperate Chinese government will further tolerate the inflation of bubbles which has brought public and private debts to already precarious levels. 

Rising yields of Chinese 10 year bonds will serve as a natural barrier to the bubble blowing policies by the Chinese government. The sustained rise of interest rates in China may prick China’s simmering property bubble that would lead to a disorderly unwinding that risks a contagion effect on Asia and the world.

Europe’s Bizarre Divergences 

Yet, rising UST yields has thus far affected Europe and Asia distinctly.

Bond yields of major European nations[16] as Germany, United Kingdom and France have been on the rise, the former two have resonated with the US counterpart. Yields of German and UK bonds have climbed to a two year high as shown in the upper window [GDBR10:IND Germany red, GUKG10:IND United Kingdom yellow and GFRN10:IND France green].

Paradoxically bonds of the crisis stricken PIGS have shown a stark contrast: declining yields [GGGB10YR:IND Greece green, GBTPGR10:IND Italy red-orange, GSPT10YR:IND Portugal red and GSPG10YR:IND Spain orange.]

I do not subscribe to the idea that such divergence has been a function of the German and French economy having pushed the EU out of a statistical recession last quarter[17]. Instead I think that such deviation has partly been due to the yield chasing by German, UK and French investors on debt of PIGS. But this would seem as a temporary episode.

Such divergences may also be due to furtive manipulation by several European governments given the election season. As this Bloomberg article insinuates[18]:

The bond-market calm that has descended on the euro area in the run-up to next month’s German election masks unresolved conflicts that have frustrated the region’s leaders for more than three years.

Greece needs more debt relief, the International Monetary Fund says; Portugal is struggling to exit its support program; Spanish Prime Minister Mariano Rajoy is battling corruption allegations and calls to resign; France faces unrest as Socialist President Francois Hollande follows through on his promise to cut pension-system losses.

But if the bond vigilantes will continue to trample on the bond markets then eventually such whitewashing will be exposed.

The Fed’s Portfolio Balancing Channel via USTs

In my opening statement I said that every stock market bulls have either ignored or dismissed the activities of the bond vigilantes as irrelevant to stock markets pricing.

It seems that the mainstream hardly realize that USTs have been the object of the Fed’s QE policies. In other words, what the mainstream ignores is actually what monetary officials value.

The FED now owns a total of 31.47% of the total outstanding ten year equivalents according to the Zero Hedge[19]. And with the current rate UST accumulation by the FED, or even with a “taper” (marginal reduction in UST buying), eventually what used to be a very liquid asset will become illiquid. This would even heighten the volatility risks of the UST markets.

The FED uses USTs as part of the policy transmission from its “Portfolio Balance Channel” theory which intends to “affect financial conditions by changing the quantity and mix of financial assets held by the public” according to Fed Chairman Bernanke[20]. This will be conducted “so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar asset”

In other words, by influencing yield and duration through the manipulation of the supply side of several asset markets, such policies have been designed to alter or sway the public’s perception of risk and portfolio holdings in accordance to the FED’s views.

Unfortunately the above only shows that markets run in different direction than what has been centrally planned by ivory tower based bureaucrats.

Whether in the US, Europe or Asia, where policymakers have been touting of the perpetuity of accommodative or easy money conditions, markets, as the revealed by bond vigilantes, has been disproving them. Soaring bond yields flies in the face of “do whatever it takes” promises.

Bottom line: Rising UST yields have been affecting global asset markets at a distinct or relative scale. 

Rising yields has been a function of a combination of factors such as the growing scarcity of capital or the shrinking pool of real savings at an international level, the unsustainability of inflationary boom, the Triffin Paradox, growing scepticism over central bank and government policies and of the unsustainability of the current growth rate of debt and of the present debt levels (see chart above[21]).

While so far, Asia and other Emerging Markets appear to be the most vulnerable, should bond yields continue to soar, which implies of amplified volatility on the bond markets and eventually interest rate markets, the impact from such lethal one-two punch will spread and intensify.

This makes global risks assets increasingly vulnerable to black swans (low probability-high impact events) accidents.

Caveat emptor.

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[1] See Don’t Worry Be Happy Stock Markets Ignores the Bond Vigilantes August 14, 2013

[2] See Emerging Market Rout: Prelude to a Global Crisis? June 27, 2013

[3] See The Wile E. Coyote Moment: US Treasury Yields Spikes! June 11, 2013

[4] Investopedia.com Margin Debt

[5] Zero Hedge Deutsche Bank Hopes "Not All Margin Calls Come At Once In Case Of A Sell-Off" August 13, 2013

[6] New York Stock Exchange Securities market credit ($ in mils.), 2013 www.nyxdata.com

[7] Reuters.com China, Japan lead record outflow from Treasuries in June August 16, 2013

[8] See Mayhem in the US Treasury Markets, No Problem, China to the Rescue! July 18, 2013

[9] US Treasury MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

[10] Wall Street Journal Japanese Investors Buy Foreign Debt As Domestic Rates Fall August 14, 2013

[11] See Global Equity Markets: Signs of Distribution and Japan’s Capital Flight April 8, 2013

[12] Real Time Economics Blog Japan GDP Clouds Tax Debate Wall Street Journal August 12, 2013

[13] Wall Street Journal Bond Funds Outflows Shouldn't Panic Investors August 16, 2013

[14] Tradingeconomics.com CHINA GOVERNMENT BOND 10Y

[15] Bloomberg.com China July Home Prices Rise as Big Cities Post Record Gains August 18, 2013

[16] Bloomberg.com Rates & Bonds

[17] BBC.co.uk Eurozone edges out of recession

[18] Bloomberg.com Europe Muddles to German Vote as To-Do List Grows August 15, 2013

[19] Zero Hedge Good Luck Unwinding That August 15, 2013

[20] Chairman Ben S. Bernanke The Economic Outlook and Monetary Policy At the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming August 27, 2010

[21] Zero Hedge Dylan Grice On The Intrinsic Value Of Gold, And How Not To Be A Turkey July 31, 2013

Quote of the Day: The goal of Nixon Shock is to get foreign governments to hold US debts

Nixon unilaterally abolished the monetary agreement established in 1944 at Bretton Woods, New Hampshire. At that meeting, the United States, Great Britain, and other Western nations established a new monetary order. It would be supported by the United States Treasury. The United States Treasury would guarantee that any central bank or foreign government could buy gold from the Treasury at a price of $35 per ounce.

The goal of the Treasury was simple: to get foreign governments to hold Treasury debt instead of gold. Because Treasury debt was supposedly as good as gold, foreign governments and central banks could hold Treasury debt instead of holding gold. This enabled the United States government to run fiscal deficits, and foreign governments and central banks financed a portion of this debt. They did so by creating their own domestic currencies out of nothing, and then using these currencies to buy U.S. dollar-denominated debt, meaning U.S. Treasury debt. It was a nice arrangement. Foreign governments and foreign central banks gained an interest rate return on holding treasury debt, which they could not get by holding gold. Yet the dollars that they were being promised by the Treasury were supposedly as good as gold.

This is an extract from Austrian economist Gary North’s article in remembrance of the Nixon Shock or the closing of the Bretton Woods Gold Exchange Standard 42 years ago today.  

This shift towards the fiat money US dollar standard regime magnifies the Triffin Dilemma, where recent improvements in US trade and budget deficits could mean trouble ahead for global markets and economies.

Will the Triffin Dilemma Haunt the Global Financial Markets?

As measured by the Dow Jones Industrials US equity benchmark suffered their first loss in 7 weeks. Are these signs of fatigue or are these signs of an overheating or climaxing bubble? 

My impression is should US markets begin to wilt in earnest, then current downdraft in Asian markets are likely to intensify.

The US reportedly posted a substantial 22% reduction in the deficits of her trade balance owing to record exports and to a shrinking oil import bill according to the Wall Street Journal[1]. 

Shrinking US trade deficits can signify a symptom of unsustainable imbalances from the current monetary order, the US dollar standard.

The US dollar remains the largest international foreign exchange reserve with over 60% share (right window[2]).

International currency reserves are over $10 trillion with the US Dollar also having the biggest share (left window). Perhaps a big segment of the undisclosed reserve currency may also be in US dollars.

Over 50% (right window) of the $12 trillion (left window[3]) of international debt securities has been denominated in US dollars.

The point of this exercise is to demonstrate of the world’s continuing dependence on the US dollar as medium of exchange and as reserve currency.

Yet the US dollar standard seems to operate on the principle of the Triffin Dilemma, formulated by the late Belgian American economist Robert Triffin.

The eponymous theory by Mr Triffin elucidates of the economic conflict emanating from a world reserve currency particularly on meeting short term-domestic interests as against long term international objectives[4]

Under the Triffin dilemma, the issuing reserve currency makes it easy for a nation to consume more goods and services via an overvalued currency.

The same overvalued currency easily allows for financing of either budget deficits and or trade deficits, aside from having more latitude in “determining multilateral approaches to either diplomacy or military action”[5].

In short, a reserve currency provides the issuer the privilege of an interim “free lunch” or to quote the French economist Jacques Rueff “deficit without tears”[6]

One of the other side effects of the Triffin dilemma has been the intense deepening of the financialization of the US economy[7]. 

Instead of producing goods, the US economy evolved towards shuffling of financial papers partly required by foreigners to recycle their dollar holdings. As one would note, the gist of expansion of financialization came as the US dollar became unhinged from the Bretton Wood System in August 1971.

Of course the other side effect of the Triffin dilemma has been the growing frequency of global bubble cycles as evidenced by the greater incidences of global banking crises since the Nixon Shock of 1971

Aside from the massive accumulation of reserve currency by foreigners that would eventually undermine the reserve currency status, a dynamic which the world seems headed for, an equally detrimental factor to a reserve currency status is the proportional devaluation that would shrink these deficits.

Mr. Triffin actually articulated the problems of the Bretton Woods System where the failed system seemed to have validated his thesis. 

In a testimony before the US congress in November 1960, Mr Triffin argued that “If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.[8]”

Given the deep reliance by global markets and global economy on the US dollar system, improving US trade deficits are likely to extrapolate to reduced liquidity in the ex-US global system. Such dynamic will only provide more muscle or ammunition for bond vigilantes, and equally, would mean a tightening of a system deeply dependent on the largesse of US dollar steroids from US authorities.

In the recent past, a reduction in the deficits of US trade balance coincided with strains in the global ex-US equity markets as measured by the MSCI[9] (lower pane)

Diminishing trade deficits here functioned as symptoms to dot.com bubble bust and to the 2008 Lehman bankruptcy. When financial markets collapsed as consequence to a bubble, international trade grinded to a near halt. This led to a substantial reduction of US trade deficits. Thus the narrowing trade balance coincided with recessions.

The causal flow may or could be reversed today; perhaps reduced liquidity from US exports of her currency the dollar may incite instability in the global financial markets.

The effect of shrinking liquidity on the global system will likewise affect US corporations. With 34% of the revenues of US S&P 500 companies coming from non-US sales[10], the adverse effect is that shrinking global liquidity will eventually land on US shores.

And it’s not just trade deficits that has contracted, US budget deficits have also dwindled to 4.2% of the GDP from 7.7% a year ago[11]. So this could be a one-two punch against the global markets and economy. And should the FED taper, such will exacerbate on the effects of the Triffin Paradox.

Will the European Central Bank, the Bank of Japan, the Bank of England and the People’s Bank of China fill in the vacuum from improving US twin deficits?

Or will Triffin’s ghost haunt the global financial markets?

Interesting times indeed.

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[1] Wall Street Journal Oil Boom Helps to Shrink U.S. Trade Deficit by 22% August 6, 2013

[2] The European Central Bank THE INTERNATIONAL ROLE OF THE EURO July 2013 p.19

[3] The European Central Bank, op cit., p23

[4] Wikipedia.org Triffin dilemma

[5] See The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency April 20, 2009

[6] Jacques Rueff, The Monetary Sin of the West, Mises.org

[7] Wikipedia.org Financialization

[8] IMF.org The Dollar Glut Money Matters: An IMF Exhibit—The Importance of Global Cooperation System in Crisis (1959-1991)

[9] MSCI.com World Ex-US MSCI Index Performance

[10] Businessinsider.com CHART: The S&P 500 Is Not The US Economy, May 10, 2013

[11] National Forex Calculated Risk; US Deficit is Shrinking August 10, 2013

The Political Pretense called Currency War

A geneticist recently claimed that human intelligence has been on a gradual decline due to the extensive use of fluorides in the water supply, pesticides, high fructose corn syrup and processed foods. 

I have a different opinion. If true, then I would say that the main culprit has been the public’s worship of state, from which untruths, as conveyed by media, politicians and their apologists, envelops its essence. Blind belief in political falsehood makes people lose their intellectual bearings.

Just recently the Japanese government has been blamed by her counterparts as Russia, South Korea and the Bundesbank for inciting, if not escalating, a “currency war” via open ended bond buying program to devalue the yen. The implication is that Japan’s “currency manipulation” polices signifies as “beggar thy neighbor” policies that have been implicitly designed to hurt other nations.

A “currency war” is another term for competitive devaluation which according to Wikipedia.org represents “a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency” where “states engaging in competitive devaluation since 2010 have used a mix of policy tools, including direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing.”

Yet one would notice that the balance sheets of major central banks, all of which have been skyrocketing, and which allegedly reflects on “direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing”, currency wars in the light of competitive devaluation has been an ongoing event since 2008 as shown in the chart above. 

In short, neither has this been an exclusive Japan event nor has been a fresh development.

And this has also not been limited to major central banks but extends all the way to emerging Asia and to China as well, the Philippines included. (chart from the Bank of International Settlements)

In short, global central banks have been in a state of “currency war” or “currency manipulation” since 2008.

This article is not meant to absolve Japan's policies but to expose on what seems as political canard.

In reality “currency war” or “currency manipulation” or competitive devaluation is simply nothing more than inflationism. The great Ludwig von Mises defined inflation as

if the quantity of money is increased, the purchasing power of the monetary unit decreases, and the quantity of goods that can be obtained for one unit of this money decreases also.

While there may be technical difference on what a central bank buys to expand her assets through a corresponding expansion of currency liabilities, the fact is that “quantity of money is increased”.

The assets of Swiss National Bank have mostly been in foreign currency reserves (as of November 2012) while the Bank of Japan has mostly been in JGBs (as of September 30, 2012). Table from (SNBCHF.com)

American neo-mercantilists have labeled “currency manipulation” on nations, who allegedly use of accumulation of currency reserves as exchange rate policy, from which they call their government to impose protectionist countermeasures such as China.

As I wrote previously this represents naïve thinking.

While the technical reasons why countries accumulate foreign currency reserves are mainly for self-insurance (for instance Asia reserve accumulation has partly been due to the stigma of the Asian Crisis) and from trade, financial and capital flows (NY FED), the real “behind the curtain” reason has been the US dollar standard system. Such system allows for a “deficit without tears”, or unsustainable free lunch by the use of the US dollar seingorage to acquire global goods and services that results to seemingly perpetual trade deficits. 

Deficit without tears, as the late French economist and adviser to the French government Jacques Rueff wrote in the Monetary Sin of the West (p.23), “allowed the countries in possession of a currency benefiting from international prestige to give without taking, to lend without borrowing, and to acquire without paying.” 

And this has been the main reason for America’s “financialization” and the recurring policy induced boom bust cycles around the world, which essentially has been transmitted via the Triffin dilemma or “the conflict of interest between short-term domestic and long-term international economic objectives” of an international reserve currency

Thus blaming China or even the Philippines for reserve currency accumulation seems plain preposterous and only represents political lobotomy.

Currency war or currency manipulations serves no less than to “cloak the plea for inflation and credit expansion in the sophisticated terminology of mathematical economics”, to quote anew the great professor Ludwig von Mises from which “to advance plausible arguments in favor of the policy of reckless spending; they simply could not find a case against the economic theorem concerning institutional unemployment.”

And may I add that pretentious public censures account for as ploys to divert public’s attention or serve as smokescreens from homegrown government “inflationist” policy failures.

Since major central bank represented by the G-20 knows that by labeling Japan as instigator of currency wars would be similar to the proverbial pot calling the kettle black, they went about fudging with semantics to exonerate Japan’s political authorities.

From Bloomberg,

Global finance chiefs signaled Japan has scope to keep stimulating its stagnant economy as long as policy makers cease publicly advocating a sliding yen.

The message was delivered at weekend talks of finance ministers and central bankers from the Group of 20 in Moscow. While they pledged not “to target our exchange rates for competitive purposes,” Japan wasn’t singled out for allowing the yen to drop and won backing for its push to beat deflation.

This doesn’t look like a “war”, does it?

At the end of the day, currency war, or perhaps, stealth collaborative currency devaluation (perhaps a modern day Plaza-Louvre Accord) maneuvering means that central bank shindig will go on; publicity sensationalism notwithstanding.

The US Dollar Renminbi Standard Myth

Another bizarre mercantilist claim today is that the world monetary system operates on a supposed “USD-Renminbi” standard.

(From Tradingeconomics.com)

Such claim has been anchored on supposed “trade imbalances”, particularly US trade deficits, from where the world evolves only around only two nations, the United States and China. From such premise it is easy to dismiss this as false choice.

A further assumption is that central bankers of both nations have only been fixated on each other’s economy while ignoring the rest of world.

Nevertheless here a few charts to dispel such myths

Based on merchandise trade, it would be a mistake to assume that both these countries equally been trade oriented.

The fact is that the US despite the deficits, external trade in goods account for only a little over 20% of the economy. This makes the US essentially relatively a closed economy.

Meanwhile China’s merchandise trade is about half their economy. In contrast Germany’s external trade accounts for more than 70%. 

Germany largest share among the three squares with the EU’s position as the largest trading bloc. (Wikipedia)

To further add, China accounts as the second largest trading partner to the United States. (US Bureau of Commerce)

Also in terms of trade deficit with the US, while it is true that China has the largest surplus, there are many other countries that maintains where the US has a deficit. (US Bureau of Commerce) Add all to the 9 largest trading partners with surpluses these will easily overshadow China. A further implication is that should protectionist measures be imposed on China, US deficits will only shift to these countries.

Yet for those blinded by deficits, they fail to also account that China’s exports have been (51%) owned by foreign owned companies based on China.

In reality, the obsession towards trade deficits are misleading for the simple reason that trade deficits are balanced out by capital account (Mark Perry)

To quote Professor Mark Perry (bold original)

As a direct consequence of our current account deficits, the U.S. economy has been the beneficiary of more than $8 trillion worth of capital inflows from foreigners since 1980. Because the Balance of Payment accounts are based on double-entry bookkeeping, the annual current account and capital account have to net to zero, so that any current account (trade) deficit (surplus) is offset one-to-one by a capital account surplus (deficit) and the balance of payments therefore always nets out to (equals) zero. And that's why it's called the "balance" of payments, because once we account for trade flows and capital flows, everything balances, and there are no deficits or surpluses on a net basis.

The other side of the coin is that China’s ownership of US debts has been overstated.

In reality, foreign ownership as a total of US treasuries account for only 25% (Wikipedia)…

…where China owns about 8% share of total foreign ownership as shown by the breakdown above. 

In terms of international currency reserves…

The Euro-USD constitutes 90% of global foreign exchange reserves. Add the pound sterling, yen and the swiss franc such would account for 95% of foreign reserves. (Wikipedia) In other words, global trade and banking reserves have hardly been about the Chinese yuan yet. Although China has been making inroads with other emerging markets (e.g. ASEAN, Brazil India Russia, Chile and even Africa) to use her currency as an international reserve.

China’s fixed currency has partly been accused for such relationship. But China’s currency has been fixed since 1994. If fixing currency to the US dollar has been about stealing jobs…

…then all these countries have been guilty

But then again, currency fixing or pegging has been adapted by these countries mostly to promote stability.

According to Investopedia.com

The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Other reasons have been for expanding trade network externalities and importing policy credibility, (University of California) aside from lack of depth in their respective domestic and sophistication in domestic financial markets. 

Bottom line: As I have been pointing out, US trade balance, aside from the conditions of the US dollar has mostly been a function of domestic boom bust cycles, the Triffin dilemma (frictions arising from the collision of international and domestic interests based on short and long term objectives) and many other domestic interventionists policies. 

There has not been a single factor. (Fallacy of a single cause)

Financialization of the US has been an outgrowth of these from which trade deficits have been funded through the growth of financial industry. Wikipedia points to the “greater role arising from the issuance of fiat currency untethered to gold or other commodities, as well as the “end of the post-World War Two Bretton Woods system of fixed international exchange rates and the dollar peg to gold in August 1971”. 

Neither has supposed trade imbalances been deliberately caused by China.

Boom bust cycles, for instance, draw in lots of resources and labor to malinvested areas where during a booming phase distorts the price mechanism and distribution and production process via overvaluing wages, the domestic currency, asset prices, welfare (pensions), fake profits and etc....

Once a bust arrives these policies induced boom becomes key sources of retrenchment.

Mercantilists have been flagrantly blind to this.

Finally as I pointed out, Ben Bernanke has not been targeting the exchange rate for his latest QE. This means, if you believe his uprightness, then he acknowledges that the issue has been local, particularly putting a floor on asset prices and hardly about foreign (devaluation).

Seeing things from reality (than from political biases) gives us a better chance at being right in our investment positions.