Return of the Bond Vigilantes? China and Russia Blasts Debt Ceiling Bill

Back to the debt ceiling bill, foreigners as the BRICs represent as pivotal forces, whom could function as bond vigilantes (bond market investors who protests monetary or fiscal policies they consider inflationary by selling bonds, thus increasing yields) and who could substantially sway US sovereign bond prices or the direction of interest rates.

Some of these significant bond holders have reportedly criticized the debt bill.

From Bloomberg,

China, the largest foreign investor in U.S. government securities, joined Russia in criticizing American policy makers for failing to ensure borrowing is reined in after a stopgap deal to raise the nation’s debt limit.

People’s Bank of China Governor Zhou Xiaochuan said China’s central bank will monitor U.S. efforts to tackle its debt, and state-run Xinhua News Agency blasted what it called the “madcap” brinksmanship of American lawmakers. Russian Prime Minister Vladimir Putin said two days ago that the U.S. is in a way “leeching on the world economy.”

The comments reflect concern that the U.S. may lose its AAA sovereign rating after President Barack Obama and Congress put off decisions on spending cuts and tax increases to assure enactment of a boost in borrowing authority. China and Russia, holding a total $1.28 trillion of Treasuries, have lost nothing so far in the wake of a rally in the securities this year.

“It’s probably frustration more than anything else for China,” said Brian Jackson, a senior strategist at Royal Bank of Canada in Hong Kong. While the nation has concerns, “they realize there’s not a lot of options for them out there and so they need to keep buying Treasuries.”

China held $1.16 trillion of Treasuries as of May, U.S. Treasury Department data show. The nation has accumulated the holdings as a by-product of holding down the value of its currency, a policy U.S. officials have said gives China an unfair advantage in trade.

Apparently these have not just been political talk but appear to have been accompanied by action

Charts from yardeni.com

Foreign appetite for US bonds has been on a decline, with China accounting for the gist.

As earlier discussed, the local savers through private banks have been shackled by various regulations particularly the Basel Accords, which compels the banking industry to divert these savings to finance government expenditures. This has been called as Financial Repression by some experts. Once the bond market unravels, many of the private sector money tied due to such regulations will get burned.

Yet with the debt ceiling bill currently lifted to $16.5 trillion, and where the US Federal Reserve has taken over the bulk of the financing of the ballooning US deficits via the QE 2.0 from declining interests from foreigners, the $64 gazillion question is ‘will the US government allow interest rates to go up which increases the risks of popping the banking system’s ultra fragile balance sheets?’

Graphic above from PIMCO’s Bill Gross

I don’t think so.

And it has been part of the central banking dogma or quasi operating manual to inflate the system when some form of distress emerges.

This can be exemplified by the actions of the SNB on the Swiss Franc and the BoJ on the Yen during the past 24 hours. And that’s why, given the mounting risks of a bond auction failure, sluggish asset markets and the desire to keep interest rates at current levels or ‘Zero bound’, we should expect the next round of asset purchases by the US Fed to happen soon.

And this is also why fissures on the US dollar system continue to widen.

From another Bloomberg article

The committee of bond dealers and investors that advises the U.S. Treasury said the dollar’s status as the world’s reserve currency “appears to be slipping” in quarterly feedback presented to the government.

The Treasury Borrowing Advisory Committee, which includes representatives from firms ranging from Goldman Sachs Group Inc. to Pacific Investment Management Co., said the outperformance of haven currencies and those from emerging nations has aided in the debasement of the dollar’s reserve status, according to comments included in discussion charts presented ahead of the quarterly refunding. The Treasury published the documents today.

“The idea of a reserve currency is that it is built on strength, not typically that it is ‘best among poor choices’,” page 35 of the presentation made by one committee member said. “The fact that there are not currently viable alternatives to the U.S. dollar is a hollow victory and perhaps portends a deteriorating fate.”

What is unsustainable won’t last. The bond vigilantes are lurking around the corner and substantially higher interest rates will be the future. That’s what record gold prices have been admonishing us.

For now, profit from political folly.

(hat tip Dr. Antony Mueller)

Paper Money On Path To Return To Intrinsic Value - ZERO

Voltaire (1694-1778) once said, ``Paper money eventually returns to its intrinsic value ---- zero."

No matter how you look at it...

From Price levels...

source (Robert Sahr, Oregon State, HT: Jeff Tucker)

Or inversely translated into the currency's purchasing power...

(Source AIER)

Paper money based on the US dollar system is indeed headed towards ZERO

Source AIER

As Thomas Paine(1737–1809) an English pamphleteer, revolutionary, radical, and classical liberal once wrote, ``Paper money is like dram-drinking, it relieves for a moment by deceitful sensation, but gradually diminishes the natural heat, and leaves the body worse than it found it. Were not this the case, and could money be made of paper at pleasure, every sovereign in Europe would be as rich as he pleased. But the truth is, that it is a bubble and the attempt vanity. Nature has provided the proper materials for money: gold and silver, and any attempt of ours to rival her is ridiculous…."

The US dollar's Vitality Stems From Debt Deflation Prompted US Dollar Shortage

We have long argued that the recent strength of the US dollar, which was seen almost across most major currencies, have been mainly a function of the US dollar's role as an international currency serve. [see latest Asian Currencies Fall On CEE To South Korean Won Contagion]

Apparently the Bank of International Settlements in its Quarterly Review has a similar perspective.

The chart according to the BIS "examines cross-currency funding, or the extent to which banks invest in one currency and fund in another. This requires a breakdown by currency of banks’ gross foreign positions, where positive (negative) positions represent foreign claims (liabilities).

``For some European banking systems, foreign claims are primarily denominated in the home country (or “domestic”) currency, representing intra-euro area crossborder positions (eg Belgian, Dutch, French and German banks). For others (eg Japanese, Swiss and UK banks), foreign claims are predominantly in foreign currencies, mainly US dollars. These foreign currency claims often exceed the extent of funding in the same currency. (bold emphasis mine)

So how did the shortage come about? From the unraveling debt deflation process...

Again from the BIS (bold emphasis mine),

``European banks’ funding pressures were compounded by instability in the non-bank sources of funds on which they had come to rely. Dollar money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (see Baba et al in this issue). Less abruptly, a portion of the US dollarforeign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some monetary authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars.

``Market conditions made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities, other claims on non-bank entities – such as structured finance products – were harder to sell into illiquid markets without realising large losses. Other factors also hampered deleveraging of US dollar assets: prearranged credit commitments were drawn, and banks brought off-balance sheet vehicles back onto their balance sheets...

``The frequency of rollovers required to support European banks’ US dollar investments in non-banks thus became difficult to maintain as suppliers of funds withdrew from the market. The effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage."

Despite the tremendous amount of financing generated by the US Federal Reserve, the losses in the US banking system compounded by the pressures on the European Banking system has been far greater in reducing supply of US dollars in the global financial system. Nonetheless, all these reveals of the inherent privileges of the world's currency reserve.

In short, the factors of demand and supply of currencies dictate on relative currency values, with special emphasis over the short term, more than just economic conditions.

Fannie And Freddie Bailout Designed To Save The US Dollar Standard System

``Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.”-Brad Setser, Council of Foreign Relations, So true …

 

It was a highly volatile market out there this week.

 

The initial salvo was wild cheering from global equity markets on the recent action by the US Treasury to take its Government Sponsored Enterprise (GSE)-Fannie Mae and Freddie Mac- into “convervatorship” (quasi-nationalization). However, the festiveness quickly dissipated when the realities of “a weakening global economy”, the ramifications from the credit event of the F&F takeover on the Credit Default Swap Market and concerns over the persistent deterioration of US financial conditions as manifested by the lackluster capital raising quandary by Lehman Bros, which until recently, was the 4^th largest investment bank in the US, sunk into the consciousness of global investors which resulted to a retreat from most of the earlier gains.

 

The conservatorship program includes the taking over of management control of Fannie and Freddie (F&F) by its regulator the Federal Housing Finance Agency (FHFA), where common and preferred stock would be diluted and not eliminated. The takeover now alters the corporate objective of the GSEs to “improving mortgage financing conditions” from “maximizing common shareholder returns”.

 

The program also includes capital injection into the GSEs by US Treasury and FHFA to maintain the positive net worth of these agencies in order to fulfill its financial obligations, where in exchange the US Treasury receives “senior” preferred equity shares and warrants aimed at securing solvency.

 

Aside, a new credit facility designed to secure liquidity concerns will be introduced to backstop F&F and Federal Home Loan Banks, and which is set to expire on December 2009. Lastly, a temporary program will also be put in place to acquire GSE Mortgages in order to secure market liquidity of mortgage securities also slated to expire on December of 2009.

 

For starters, Agency securities are one of the world’s most widely held securities by both private and the public sectors (Sovereign Wealth Funds and Central banks).

 

Morgan Stanley’s Stephen Jen has a great breakdown on these (highlight mine),

 

`` Total foreign holdings of long-term USD securities increased from US$7.8 trillion in 2006 to US$9.8 trillion in 2007, with US$1.3 trillion of this annual increase from increased foreign holdings of US long-term debt securities, including US Treasuries, agencies, agency ABS and corporate bonds.  Foreigners are dominant in some of these markets.  For example, some 57% of the marketable Treasury securities are held by foreign investors. 

 

``Foreign investors’ appetite for US agencies – both straight agency debt and agency-backed ABS (also called agency pass-throughs) – has risen sharply.  (Fannie Mae and Freddie Mac (F&F) are government-sponsored enterprises (GSEs) with two main activities.  First, they securitise mortgages by converting conforming mortgage loans into tradable mortgage-backed securities (MBS).  Second, they have an ‘investment portfolio’ business, whereby they issue AAA rated agency debt to finance the holding of MBS or other assets.  The latter is a ‘carry trade’, capitalising on the then-implicit government guarantee.  One key part of the policy discussion regarding F&F is whether their second activity is justified.)   Of close to US$7.5 trillion in outstanding US agency debt and agency-backed ABS, some US$1.54 trillion (according to Fed flow of funds data, June 2008) is held outside the US, with China, Japan and AXJ being the largest holders of these securities, with US$985 billion of this latter figure held by foreign central banks. (The share of total US long-term securities held by foreign investors has more than doubled since 1994 (from 7.9% of the US$16 trillion in securities back then to 18.8% of the US$49 trillion outstanding as of 2007).” 

 

We featured a chart on the composition of foreign holdings of the F&F in Inflation: Myths And Beneficiaries. Nonetheless, private ownership of Agency backed papers appears to have stagnated since 2005 while foreign public ownership has steadily increased as shown in Figure 2.

Figure 2: Northern Trust: Foreign Public-Private Exposure On F&F

 

In perspective, aside from foreign holdings GSE debt securities are likewise owned by US households and institutions or financial entities as commercial banks, savings banks, credit unions, pension funds, life insurance companies mutual funds, brokers, ABS issuers and REITs.

 

However, as % of total outstanding debt, in 2007 ownership of GSE debt in pecking order: foreigners comprise 19.92%, followed by commercial banks 13.87%, households 12.06%, mutual funds 7.67% and ABS 5.13% (Northern Trust).

 

So when US Secretary Paulson was asked of the US government’s takeover of F&F, his reply as quoted by the Washington Post,

 

``"The U.S. government had no choice," he said.

 

``Mr. Paulson, in an interview with CNBC on Monday, said foreign pressure was not the "major driver" of the takeover, but acknowledged that "there's no doubt that there's fragility in the capital markets."

 

``"These companies are so big, and they are owned by investors all around the world. You are obviously going to get concerns," Mr. Paulson said. "It was definitely concerning overseas, but there was concern in this country. I tell you, my phone is ringing the most from investors here." 

 

This means the US financial system have reached a near calamity. 

 

However many had been quick to lash at the “conservatorship” program as virtually a bailout of foreign owners of agency securities.

 

While this perception seems partly correct, I think most of these critics ignore the fact that these actions basically signify a remedial patchwork to the emerging cracks at the Fiat Paper Money “US Dollar” standard system. The massive current account imbalances a common feature in today’s world tends to amplify on the systemic flaws especially amidst today’s heightened volatility.

 

At present, countries with current account surpluses at one side of the ledger need to be offset by countries with current account deficits at the opposite side. As an example, deficits of the US have been more than sufficiently covered for by capital flows from mostly emerging markets paving way for the unorthodox pattern of “Poor countries Financing The Rich”.

 

Yes, while various politicians and experts from around the world have boisterously decried about “social inequality”, unknowing to most is that such inflationary “inequality” mechanism appears to be the imbedded on the US dollar standard platform. Think of it, while profits are privatized, losses are socialized! Wall Street’s politically connected gets rescued, while the masses pay for the mess created by the former. The failed F&F model was demonstrative of the Keynesian brand of capitalism and not of the laissez faire genre. (Please don’t associate the fiat paper money standard as epitomizing laissez faire or free markets too. Same with currency markets, interest rate markets or even oil markets! These markets are controlled heavily by governments notably on the supply side. As an aside, the “anarchy” in the Shadow Banking System wasn’t symptomatic of a free market mess, but one of going around banking regulations or taking advantage of “regulatory loopholes” in order to take on added leverage by assuming more risk to magnify returns by the establishment of off-balance sheet Structured Investment Vehicles (SIV). Going around loopholes do not signify free market paradigms).

 

Going back to the unorthodox pattern of “Poor countries Financing The Rich”, during the gold standard, current account imbalances had effectively been curtailed by the shifts in the gold reserves by nation states engaged in trade. This essentially accounted for as an automatic adjustment mechanism, which is absent today under the digitalized and unlimited printing capabilities of central banks to churn out money “from thin air”.

 

And as we noted above, current account imbalances today need to be offset. During the recent past, the nations with current account surpluses signified as subsidies to domestic export-oriented industries but came at the expense of domestic consumers, i.e. China, Asia and other emerging markets. On the other hand, current account deficit nations run subsidies on domestic consumers via expanding domestic debt (financed by current account surplus countries) at the expense of domestic production. From which the transmission mechanism had been mainly via currency pegs or dollar links.

 

The foreign buying of agency papers or US debts were meant to sustain mercantilists’ policies by frontloading currency and interest rate risks in order to keep the exchange rate undervalued and thus promote domestic export oriented industries in order to expand employment. Hence, the currency manipulation policies that led to the current account imbalances had primarily been meant as a tool to manage domestic political risks.

 

In other words, the US dollar standard system paved way for political imperatives over economic goals, see figure 3.

Figure 3: Asianbondsonline.com: China-US yield curve

 

What sense would it make for a current account surplus country as China to buy or load up on assets of a depreciating currency, thereby suffer from currency loss? What sense too for current account country as China to buy assets whose yield is less than what is offered domestically, thereby suffer from opportunity cost of low interest rate spreads (assuming holding bonds until maturity)? And this has been going on for years!

 

The same for deficit countries, domestic consumers had been financed to go into a debt driven asset buying binge which resulted to overleveraged driven massive speculation, again for political goal of sustaining finance driven economic booms, where the demand from domestic consumption boom has greased the industries of current account surplus countries as China and emerging countries.

 

The US dollar, functioning as the world’s de facto currency reserve currency, has fundamentally been used by the US government to freely load up on debt, given its special privilege to underwrite from its own currency, by selling almost unlimited financial claims to international investors to finance such speculative unsustainable booms.

 

And as the US real estate and financial boom has basically unraveled, all these seem to be in a transition.

 

Recently there had been some signs of reluctance of nations with current account surpluses to stack up into agency papers. Of course, the recent actions by the US Treasury may seem to have assuaged the concerns of repayment by buying more into US treasuries instead of agency papers.

 

So what can we see from all these?

 

One, current account surpluses nations or foreign central banks seem to have the tolerance bandwidth, given their accrued currency reserves, to suffer from the risks of currency and interest rate losses provided they get repaid for holding these securities until maturity. I guess the actions by the US treasury may have answered such “repayment” concerns.

 

Two, foreigners which have been formerly financing the US real estate securitization boom appears to be bailing out, if not help tacitly ‘nationalize’ the structurally beleaguered industries by buying into agency papers until recently.

 

It also reveals of the extent of overdependence or vulnerability of the US on relying on foreign financing. The risk seems such that if foreign central banks or state owned Sovereign Wealth Funds or affiliated institutions would deem to have accumulated more US dollar reserves than what they might think is required, and change their priorities by reducing finance exposure to the US, which can even lead to more volatility in the US. Political factors can also hold sway to the appetite of foreign financing of US deficits.

 

In addition, understanding its present predicament and limitations, the “capital short” US government seems to be working feverishly to attract or to intermediate for foreign capital participation into buying out its besieged financial institutions. Example, a syndicate led by UK’s 3^rd largest bank, Barclay’s along with a “club rescue” team of “Temasek of Singapore and China Development Bank, was reportedly have shown willingness to back a deal that would put Barclays in the top tier of financial institutions.” (timesonline.co.uk)

 

Three, it’s all about the increasing integration of geopolitics or the decreasing hegemony of the US, as seen in the “Poor financing the Rich” aside from “Autocratic and non-democratic states financing democratic countries”!

 

Some Poor but Autocratic/non democratic nations that have been a beneficiary to the ongoing wealth transfer appear to have accumulated enough political clout as to weigh on the internal political policymaking of the US. 

 

Remember this quote from Yu Yongding, a former adviser to China's central bank quoted last in our Will King Dollar Reign Amidst Global Deflation? ``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.” The recent political actions employed by the US government appeared to underscore such circumstances and Mr. Yu’s prayers seems to have been answered.

 

Or how about Russia’s recent military offensive against Georgia (as discussed in Toynbee’s Generational War Cycle: In Mindanao or In Georgia/South Ossetia?) which has practically left the US as a political nonparticipant to a besieged ally?

 

This only goes to show how the US looks to be losing its imperial edge over the global geopolitical economy and how the US dollar standard system appears to be in greater jeopardy.