What Will Happen to the Dollar if Foreigners Stop Funding Our Profligate Spending?

Thanks to the readers for all the e-mails so far. Most have concentrated on the problem of foreign ownership of U.S. debt, and the potential impact on the dollar should foreigners stop funding our profligate spending.

First, let’s make a distinction between debt monetization and what the Fed is currently doing with their Treasury buying program. A classic debt monetization is a solution to overwhelming domestic debt. Its printing money to actually pay off the debt because the government has no other solutions. If you want to claim that the Treasury might someday get to this point, have at it. But its clear that in the here and now, the Fed’s buying program isn’t meant to solve the problem of deficit spending. The Fed wants to buy Treasury bonds in an attempt to put more money into the U.S. economy in the name of fighting deflation. It might also be an attempt to force interest rates lower, although I’m increasingly doubtful that is their intention. Either way, Treasuries are just serving as the helicopter out of which the Fed is throwing money. In other words, Treasuries are a means to an end. In a monetization, buying Treasuries is an end of itself.

That being said, its legitimate for foreign investors to fear the possibility of a monetization. I can’t say its out of the realm of possibility, and if your China, it would be such a disaster, they have to be watching it.

Right now, I think the U.S. and China are living in a state of mutually assured destruction. China has too much invested in U.S. dollars, and thus can’t afford to have it tank. Meanwhile the U.S. has borrowed too much from China. We can’t afford to have the Chinese exit.

Therefore thinking about Chinese exit is a bit like thinking about a nuclear attack during the cold war. Can’t deny the possibility, but it wouldn’t be in anyone’s interest to allow it to happen.

How worried are foreign investors? So far they are mostly just talking. Here is the bid/cover ratio on recent 2yr, 5yr, and 10yr auctions. If the Treasury is auctioning $20 billion and the bid/cover is 2, that means they they got $40 billion in total bids.

No obvious pattern here. Plenty of buyers for Treasuries. For me, I don’t take much from any given bid/cover, because a bid at any price counts. I.e., if you bid 4% for the new 10-year, that counts as a bid, even if that’s actually 40bps away from where the 10-year is. But as long as the bid/cover is solidly above 1, we aren’t in danger of a failed auction.

Another worthwhile auction stat to watch is indirect bidders, where foreign central banks normally hide out.

No real pattern here either.

TIC data measures foreign buying directly, but its always a little dated. Anyway, here is net purchases (buys minus sales) of Treasuries. The red line is a 12-month rolling average.

Again, no obvious pattern of selling. Now if you want to see what foreign panic looks like, check out the chart on Agencies.

The Jutland Wastes are not to traveled lightly! I’ve heard the Russians blew out all their Agency positions entirely, but I’ve also heard Chinese insurers say they’d be a natural buyer of GSE debt if it were indeed full faith and credit. Part of this too reflects an overall decline in Agency issuance, but let there be no doubt, foreigners panicked after FN/FRE conservatorship.

The overall TIC does show some pattern of decline…

But it appears to reflect a change in risk tolerance. Since overall TIC is declining while Treasury purchases are about flat, it means that foreign portfolios are more heavily Treasury weighted than in the past.

I’ve said before that the dollar won’t have the same dominance as a reserve currency in 25 years. But I be surprised if the impact is felt in any given year. The big foreign bond buyers have come face to face with a dollar disaster. Just because it didn’t happen doesn’t mean it won’t result in changes. But they will be long-term changes. The kind that are hard to trade on.

To those who really fear a China sell-off, my challenge is to show me hard evidence that its happening.

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