The run on the dollar that could sink its value and bring surprise hyperinflation to the U.S. has just become a lot more likely. China and Japan are moving to trade each other’s currencies directly rather than use the U.S. dollar as an intermediary. This won’t lead to an immediate shift away from the dollar. After all, the greenback has constituted around 60% or so of central banks’ foreign currency holdings since at least 1995, according to the IMF’s COFER report.
The change does signal to other nations that America’s main trading partners will favor the illiquidity risk of less-traded currencies over the valuation risk of holding dollars tied to unsustainable spending. China and Japan do have debt problems of their own, but they may be wagering that two drunks trying to stand each other up over the Sea of Japan is less tiresome than levitating a much larger drunk off of his back from across the Pacific Ocean. They may even print some more of their own currencies just to have the liquidity to buy each others’ bonds. The Fed isn’t the only player around that can do quantitative easing.
The U.S. financial elite should take a breather from its construction of swap lines for the eurozone to pay attention to this news. America’s deficit spending since 9/11 constituted a transfer of wealth from Asian central banks and sovereign wealth funds to shareholders in U.S. defense contractors and Medicare vendors. Trade partners who opt out of petrodollar recycling will make it harder for the U.S. to peddle dollar-denominated debt outside the U.S., because there will be fewer nations willing to keep an inventory of dollars to buy it.
In any case, China and Japan have just quietly removed a source of demand for dollars. This deal is another sign of higher U.S. interest rates to come, hyperinflation or not.
Full disclosure: Long FXI with covered calls.