Recent USD weakness has brought more nervousness in the market. Apart from the EUR and AUD the currency is losing rapidly its value against gold. How is this compatible with our deflationary view? Last week we got further confirmation the deleveraging process is still far from over. US consumer credit contracted more than expected (- $12 billion), and it isn’t showing any sign what so ever of slowing down. Headlines like Barclays wanting to spin off a £ 4 billion structured credit portfolio should be considered as part of the deleveraging process the global economy is going through as well. This should keep consumer prices contained.
Then the Federal Reserve is doing its outmost best to inject some inflation into the system. This is certainly the case for some asset classes such as equities and commodities. Last weeks rhetoric from Fed members Tarullo and Fisher, who is famous for being a hawk, already indicated the Fed will stay on hold for “an extended period” of time. Also the Fed’s 5year-5year forward breakeven inflation rate has been dropping consistently since its spike back at the beginning of August. So no signs of inflation there either. But still gold is touching new historic highs against the USD.
The explanation behind all this might very well be a distrust from foreign investors in how the US Government will succeed in managing this Mount Everest of debt they are building up. There are reasons to believe central banks are already distancing themselves from the USD.
Recent US Treasury auctions showed however good appetite for USD debt paper. The bid-cover ratio has been well above 2%. And foreign central banks subscribed well above $ 250 bln. But the question is whether this is reflecting what is really going on behind the scenes. The Treasury International Capital Flows (TIC) data shows that foreign demand for USD paper is falling off a cliff.
Figure 1: Foreign Assets in the US: Net, Capital Inflow
Source: US Department of Commerce – Bureau of Economic Analysis
This has a direct impact on the value of the USD, as foreigners are net sellers of US assets. The US spending spree financed by foreigners during this decade is also very well illustrated in Figure 1. From 2001 onwards until the breakout of the Great Credit Crisis in 2007 foreigners bought massively US assets. It was part of the build up of a current account and trade balance deficit. The US was the consumer of last resort and the oil-exporting and Asian economies re-invested these revenues back into the US. This US asset buying stopped abruptly from the moment the US consumer couldn’t use his house as an ATM machine.
It does not take a rocket scientist to figure out what would happen to the USD if this structural foreign buying flow dries up. And it is certainly an issue for a country like the US which mounting debt depends on 50% of foreigners.
According to the TIC report, foreign central banks only bought roughly $ 75.7 bln (from Jan 09 till Aug 09). At first one can argue this is highly contradictive against data from the US Treasury auction, which is over $ 250 billion. Fortunately there is no paradox here.
First of all what you need to know is that the Federal Reserve acts as a custodian bank for foreign central banks that buy US Treasuries or Agency paper. In other words the Fed holds these bonds “in custody” for these foreign banks. The TIC data is only showing the amount of capital that is entering or leaving the US, but what happens on these custodian accounts at the Fed is not told.
A first look at these custodian accounts doesn’t raise any suspicion either. The amounts on these accounts have been growing over the years. But when we have a closer look one notices something odd. Central banks have not only been buying US Treasuries, but also US Agency bonds. This is paper issued by for example Freddie Mac and does not have the same guarantee like US Treasuries. Over the years foreign central banks were buyers of US Agencies. At the beginning of October 2008 a peak was reached at around $ 970.4 bio. Over the last 10-12 months this amount has dropped by $ 207.6 billion. US Treasuries on the other hand have risen by more than $ 600 billion.
Remember the TIC data, which is pointing at $ 75.7 of new money entering the US (from foreign central banks). So how does this explain the success of the US Treasury auctions?
Chris Martenson noticed the following phenomenon already back in June.
Foreign central banks are fully supporting the new issuances, but indirectly via their huge amounts of US Agency debt that they swap with the Federal Reserve. This avoids a situation where the Federal Reserve has to start buying its own paper. Imagine which kind of panic this would cause in the bond market.
So basically out of the sale of their US Agency paper, foreign central banks keep on supporting the Fed in buying new US Treasury bonds. But in some way or another, it is ultimately the Fed that is buying its own paper.
However, as we learn from the TIC data, compared to the total of USD 600 billion that has been issued, only USD 75.7 of new money is coming from foreign central banks. In the meantime $ 552.6 billion of private money has been repatriated back abroad. This shows that there is a negative flow leaving the US and explains why the USD is has come under so much pressure recently.
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