Lombardi: Stock Market Commentary & Forecasts, Financial & Economic Analysis Since 1986

A Fiction Called the U.S. Dollar

Wednesday, April 11th, 2012
By for Profit Confidential

U.S. TreasuriesPrior to the financial crisis, the Federal Reserve bought minuscule amounts of U.S. government debt. In 2011, the Federal Reserve bought 61% of all net U.S. Treasuries issued (source: Wall Street Journal, Mar. 27, 2012).

Reread that again, dear reader, to absorb its full meaning—61% of all issued U.S. Treasuries were bought by the Federal Reserve last year.

Before the financial crisis, it was foreign countries that were the major purchasers of U.S. government debt. Since then, many countries have reduced their purchases of U.S. government debt, especially China.

In December of 2011, all foreign countries were net sellers of U.S. government debt to the tune of $21.0 billion (source: Forbes). South Korea reduced its holdings of U.S. government debt and its holdings of U.S. dollars from 63.7% of foreign currencies to 60.5% of foreign currencies.

Over the last five years, China purchased an average of 63% of all newly issued U.S. government debt. In 2010, it dropped to 45% of all newly issued U.S. government debt and now China is purchasing only 15% (source: Wall Street Journal, Mar. 27, 2012).

With the Federal Reserve being the largest buyer of U.S. Treasuries, it creates the false impression that the U.S. government debt market is functioning normally and that there is ample demand worldwide for it. However, if the Federal Reserve stops buying, who will be there to purchase U.S. government debt?

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In the U.S. government debt market, like in all other debt markets, the higher the demand, the lower the interest rate one needs to pay on their debt. The Federal Reserve is creating its own demand, thus keeping interest rates low.

Of course, as I mentioned in these pages last week, each full percentage point rise (one percent) rise in interest rates will cost the U.S. government approximately $150 billion more in interest. It is no wonder the Federal Reserve is attempting to keep interest rates low on U.S. government debt?

The other consequence of the Fed buying U.S. government debt is that it forces the American banks to buy short-term U.S. government debt. The Federal Reserve is currently conducting “Operation Twist,” which is selling short-term U.S. government debt in exchange for long-term U.S. government debt.

Well, someone has to buy that short-term debt, and that someone is a participant with no choice in the matter: the large U.S. banks. So, U.S. banks buy the short-term U.S. government debt from the Federal Reserve, and the Federal Reserve takes the proceeds and purchases long-term U.S. government debt in order to keep long-term rates low.

In the first two months of 2012, large U.S. banks bought more short-term U.S. government debt than in all of 2011, as Operation Twist ramped up. In the first two months of 2012, $78.2 billion was purchased, bringing the total amount of short-term U.S. government debt held by the large U.S. banks to an eye-popping $1.78 trillion (source: Bloomberg).

If short-term rates were to rise due to inflation (likely) or an economic recovery (unlikely), then U.S. banks would lose billions of dollars from owning short-term U.S. government debt that pays almost zero interest. Who would then bail out the U.S. banks should this occur, dear reader? You guessed it. (Please see: The Land Debt Built.)

The U.S. government debt market is currently very calm thanks to the Federal Reserve. If the Federal Reserve stops buying U.S. government debt and foreigners continue to walk away from the U.S. government debt market, then who will buy the debt? The only choice the Federal Reserve has in a bid to keep rates low is to print more money and buy more U.S. government debt to stabilize the market. This is why I see the current correction in the 10-year old bull market in gold as such a great opportunity.

Michael’s Personal Notes:

Frustrated with what they viewed as being ignored by the West and not having a prominent role in institutions like the World Bank and the International Monetary Fund, Brazil, Russia, India, China and South Africa (also known as the BRICS countries) held their first summit in Russia in 2009 to discuss their common interests.

Just three short years later in 2012 in New Delhi, the BRICS countries emerged from their meetings to declare that trade between their countries would take place in their own currencies, doing away with the use of the reserve U.S. dollar.

Just to be clear, dear reader; it takes time, money and effort to set up bank exchanges that would allow them to trade in their own currencies. It is much easier to trade in the world’s reserve currency, the U.S. dollar, than take this route.

This is significant as well because the BRICS countries represent 40% of the world’s population and 20% of the world’s gross domestic product (GDP). There is no question however, that the BRICS countries are growing their portion of world GDP faster than the West, which means that, even in a decade, the BRICS countries are going to represent a lot more than 20% of the world’s GDP.

Another major objective that was announced at this year’s summit was to increase trade among the BRICS countries themselves, in order to reduce the influence of exporting to countries in Europe and to the U.S. Trade among the BRICS countries is growing at a 28% annual rate and is expected to double in just a few years from the $230 billion worth of trade being transacted today in the BRICS countries, increasing their GDP influence.

The most startling announcement to come from the summit was the formal proposal for studying the creation of a BRICS development bank that would offer an alternative to the U.S.-dominated World Bank. The finance ministers of the BRICS countries were asked to study the possibility and report back with a proposal at next year’s summit.

The proposed development bank would allow not only member BRICS countries to apply for loans for infrastructure projects and other development initiatives, but also all developing countries in the world.

Of course, should such a bank be created, it would need to be denominated in a reserve currency, so that loans could be issued in that reserve currency to developing countries around the world.

As a surprise to no one, even though the subject has not been discussed, there is no doubt that China wants its yuan to be the reserve currency for the BRICS development bank, as China continues its quest to have the yuan become an international currency, on par with the U.S. dollar and the euro. However, considering how culturally diverse the BRICS countries are, they may develop a new currency, which will still require that China significantly back it with its yuan.

The BRICS countries represent the fastest growing countries in the world. Although only 20% of the world’s GDP today, this GDP number is rising rapidly and, as a consequence, so will the BRICS countries’ influence. The agreement to trade in their currencies and to create a BRICS development bank is a direct assault on the U.S. dollar.

As I’ve said all along, dear reader, the reserve currency status is earned, not given. This is not a good sign for the U.S. dollar longer-term, ensuring its decline and placing its reserve currency status in jeopardy.

As well, the possibility of China having its yuan as the reserve currency of choice among the BRICS countries or having the yuan back a new currency means that it will need more gold bullion to back its currency. China has only a fraction of the gold bullion that Europe and the U.S. currently hold, pushing China to be an active and aggressive buyer in the gold bullion market today.

Where the Market Stands; Where it’s Headed:

Last year, I made a crazy prediction that I believed stocks would start heading south on April 13, 2012. Looks like I was a few days early! Since Monday of this week, the Dow Jones Industrial Average has lost 581 points, a fall of 4.4%. In fact, yesterday was the worst day for the stock market since November of 2011.

We are getting close to the end of the bear market rally in stocks that started in March of 2009. (See: The Makings of a Classic Bear Market Trap.)

What He Said:

“Home-building in the U.S. will enter a quasi depression state in 2008 and the construction industry will make 2008 a record year for pink slips. I predict a major home builder will go bankrupt in 2008.” Michael Lombardi in PROFIT CONFIDENTIAL, January 10, 2008. WCI Communities, the largest U.S. luxury homebuilder, filed for Chapter 11 protection on August 4, 2008.

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Michael Lombardi - Economist, Financial AdvisorMichael bought his first stock when he was 17 years old. He quickly saw $2,000 of savings from summer jobs turn into $1,000. Determined not to lose money again on a stock, Michael started researching the market intensely, reading every book he could find on the topic and taking every course he could afford. It didn’t take long for Michael to start making money with stocks, and that led Michael to launch a newsletter on the stock market. Some of the stock recommendations in Michael's various financial newsletters have posted gains in excess of 500%! Michael has authored and published over one thousand articles on investment and money management. Michael became an active investor in real estate, art, precious metals and various businesses. Readers of the daily Profit Confidential e-letter are offered the benefit of the expertise Michael has gained in these sectors. Michael believes in successful stock picking as an important wealth accumulation tool. Married with two children, Michael received his Chartered Financial Planner designation from the Financial Planners Standards Council of Canada and his MBA from the Graduate Business School, Heriot-Watt University, Edinburgh, Scotland. Follow Michael and the latest from Profit Confidential on Twitter or Add Michael Lombardi to your Google+ circles

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