With the global economy cooling, there seems to be quite a bit of finger pointing at who is to blame. Many, including those at the Federal Reserve, blame President Trump’s trade war with China. At the same time, President Trump has been blaming the Fed’s tighter monetary policy for the slowdown. President Trump recently stated that the stock market would resume its rise once the trade war and a few other things were resolved. Even if those issues are dealt with in a positive way, it’s the Fed who is really the culprit for the slowing global growth.
Even though Fed Chair Powell stated at the American Economic Association’s recent annual meeting that he didn’t believe the Fed’s balance sheet unwind was leading to any significant disruptions in the markets, as the world’s reserve currency, any form of monetary tightening will lead to slower global economic growth.
Absent a gold standard, where paper currencies can anchor themselves to a physical metal with limited supply, the world chose to use the dollar as the world’s reserve currency after World War II. In effect, the U.S. dollar became the currency-equivalent to gold, except there is no limit to how much currency the U.S. Treasury can theoretically print.
Being the world’s reserve currency is confusing to most people. Foreign countries link the value of their currency to the U.S. dollar, which as the world’s reserve currency, is the preferred currency for global trade.
I like to envision the global dollar-market as one large interconnected superhighway. The largest roads of this highway go to other major industrialized nations who are key players in the global financial markets. From those countries, smaller roads are split off to the smaller countries and so forth, until all countries, big and small, are connected to the global-dollar highway. The cars on the road are the dollars, with most of them traveling between the major industrialized nations.
By linking currency to the U.S. dollar, we can make an inference that it is the same as linking an economy to that of the United States. As a result, the economic and political policies of the United States are felt financially around the entire world. As the world’s reserve currency manager, the Federal Reserve becomes the most powerful central bank. Policies of the Federal Reserve also have far-reaching economic impacts, since dollars continuously cycle through the global economy. When the Fed reduces the number of dollars in circulation by tightening monetary policy, it affects the entire global economic growth.
Foreign central banks receive large numbers of dollars from global trade. For example, a foreign business manufactures a product to sell to the United States. When the product hits American shores, the foreign manufacturer receives U.S. dollars in exchange. The foreign manufacturer can’t pay their suppliers or employees with dollars, as they demand local currency, so the manufacturer exchanges their dollars for local currency at their local bank.
A manufacturer may hold some dollars to buy oil or other commodities needed to manufacture their product but, in the end, they have more dollars than they need. Once the exchange is made with a local bank for local currency, the local bank exchanges its excess dollars with their central bank for local currency. This is how foreign central banks end up with lots of dollars.
Paper currency is inflationary – the more dollars a country has, the more their economy will feel the inflationary effects of them. In a sense, the United States biggest export is inflation via the U.S. dollar as the world’s reserve currency.
As global trade increases, foreign central banks accumulate more dollars. As inflation builds with our foreign trading partners, their higher costs are passed back to American consumers, which leads to domestic inflation. To minimize the effects of inflation, foreign central banks can sell their dollars on the open market for their local currency, exchange it with their local government and businesses who may need dollars, and buy U.S. Treasury bonds.
The reason foreign central banks buy U.S. Treasury bonds is to exchange their excess dollars for non-inflationary U.S. Treasury bonds. Treasury bonds pay interest, in the form of U.S. dollars, so by buying Treasuries, a foreign central bank can exchange $1,000 (the price of a bond) for an annual dividend, which is substantially less inflationary.
The inflationary effects of the U.S. dollar are also the reason most foreign central banks reinvest their maturing Treasuries since the original purpose of buying the bonds was to mitigate the inflationary effects of the dollar. It is also worth noting that U.S. Treasury bonds are the most liquid financial instrument in the world, making it easy for foreign central banks to buy more Treasuries or sell their Treasury holdings as needed.
When the Fed destroys U.S. dollars, they simply let some of their maturing U.S. Treasury bonds from their balance sheet mature. The U.S. Treasury then must borrow a bit more to cover the maturing bonds from the Fed. The Fed can’t control who buys those bonds, nor can they control the effects associated with currency destruction.
Foreign central banks are the largest purchasers of U.S. Treasury bonds since the U.S. dollar became the world’s reserve currency. At any given U.S. Treasury bond auction, it is expected that indirect, or foreign bidders, will buy more than half of the issuance. By understanding who is buying Treasuries, it is possible to extrapolate the effects of the Fed’s currency destruction plan.
When a foreign central bank uses their excess dollars to buy Treasuries, and those dollars are then destroyed by the Fed, the Fed is reducing the number of dollars available for global trade. Normally dollars that return home are spent by the Federal government into the economy which is then used to buy goods and services by consumers. Fewer dollars returning home, since they are being destroyed, means American consumers have less currency to buy goods and services abroad.
Less demand for foreign goods and services and fewer dollars in the hands of foreign central banks leads to disinflation, not inflation. It also causes the global economy to decelerate, or slow down, which started back in February 2017, as evident by the decline in foreign stock prices.
The reason foreign governments have been scrambling to create trade deals in non-dollar denominated currencies is due to the Fed’s monetary tightening. While such trade agreements will take the pressure off foreign economies, who are highly dependent on exporting to the United States, foreign central banks could choose to boycott future U.S. Treasury auctions. While experts say a foreign boycott of Treasuries would cause Treasury yields to skyrocket, foreign central banks have already started boycotting shorter-term Treasury auctions which has led to a “glitch” in the stock market.
Even though President Trump said there was a “glitch” in the stock market during December that led to its fall, the “glitch” actually began in October when direct, or domestic, bidders nearly stopped bidding at Treasury auctions. When direct bidders stopped buying Treasuries, experts proclaimed Treasury yields would race higher but the opposite happened.
The U.S. Treasury has a relief valve built into the Treasury auctions where any unsold bonds are forcibly purchased by securities dealers, most who happen to be owned by the largest banks. As securities dealers took on more bonds, the last remaining amount of liquidity in the financial system quickly dried up. Recall, liquidity is the amount of money in the financial system available to buy stocks and, as this liquidity went towards buying bonds, stock prices started falling.
The “glitch” was created from the lack of demand by direct bidders, who have likely already purchased all the Treasuries they wanted. With the Fed unwinding their balance sheet and the Federal government running record deficits, this “glitch” isn’t likely to go away any time soon. For the “glitch” to go away, the Fed would need to stop or curtail its balance sheet unwind and the Federal government would need to bring its spending down, neither of which is likely to happen in the near future.
Fed Chair Powell, along with former Fed Chairs Yellen and Bernanke, at the recent American Economic Association’s annual meeting, all agreed global growth is likely to expand over the next two years, but at a much slower rate. They also agreed the Fed’s balance sheet unwind wasn’t having any ill-effects on the global economy or stock market. Once you understand how the Fed’s destruction of money is affecting our global trading partners and the liquidity of the stock market, it’s easy to see how confused they are about the effects of their own institution’s monetary policies.
When global growth slows, foreign central banks and large U.S. commercial banks rush to exchange their U.S. dollars for U.S. Treasury bonds. The banks are the “Smart Money” and they know when global growth slows or contracts—dollar demand falls. When dollar demand falls, so does the value of the dollar. Foreign central banks and commercial banks are eager to exchange their dollars, which are likely to lose value as growth slows, for U.S. Treasury bonds, which appreciate in value as interest rates fall when growth slows or contracts.
Over the past couple of years, I have shared numerous reasons with my readers as to why U.S. Treasury yields will hit all-time lows during the next recession. Most financial experts disagree and even my most adamant readers who question my research will struggle to disagree with what I am about to share with you.
For one year I have said Treasury yields are in a topping process that was driven by a record number of speculative short contracts taken out against the U.S. Treasury bond market and once this topping process completes, yields will be headed significantly lower. My primary reasoning, excluding the deceleration in the money supply, has been that the large commercial banks are buying U.S. Treasury bonds.
In December 2018, the large commercial banks purchased $84.6 billion in U.S. Treasury bonds, the largest one month on record, going back to 1947. When factoring the purchase of Mortgage-Backed Securities (mortgage bonds) and non-MBS (other bonds), the December increase in bank-held bonds rises to $169.2 billion!
The last time commercial banks purchased anywhere close to this amount of Treasury bonds was back in October 2008, when they purchased $63.97 billion of Treasuries, just as the broad stock market tumbled into an abyss.
While the trade war with China is slowing down global growth, it is the Fed’s combined rate-hike cycle and balance sheet unwind which is causing global growth to slow and the stock market to become the most illiquid it has ever been since liquidity data has been tracked. Even if a trade deal is struck with China, the Fed’s balance sheet unwind will undermine any growth spurts that arise from the truce.
In the meantime, the largest banks are seeing that something much worse is coming and they are quickly preparing for it – the question is, is your portfolio ready for what they see is coming?
Various Support and Resistance Levels for the Stock and Bond Markets (01/07/19 – 15 min)
It’s Not About the Wall or Trade (01/09/19 – 15 min)
Weekly Economic Update (01/11/18 – 36 min)