Walking dead US dollar | Kitco News

For more than a year, the US dollar has been gaining strength relative to other currencies, including the euro, yen, yuan and Canadian dollar. On Sept. 1 the US Dollar Index (DXY) hit a 20-year high, and as the chart below shows, the index has been risen steadily all year.

Source: MarketWatch

Rising interest rates have put upward pressure on the dollar, as foreign investors pour capital into the country. The dollar has also done well because the US economy is perceived to be stronger than Europe’s, which is suffering from an energy crisis. On Aug. 22 the euro fell to a two-decade low of 0.9903 against the dollar.

The New York Times stated in July that the dollar is the strongest it’s been in a generation, citing safe haven demand, inflation, higher interest rates and worries over growth as factors.

Treasuries shunned

Bond market and gold market observers keep a close eye on US Treasury yields, particular the yield on the benchmark 10-year note. This is because the 10-year serves as a proxy for other financial products, such as mortgage rates, and it also signals investor confidence. When there is low confidence in the economy, people want safe investments, and US Treasuries are considered among the safest.

Demand for Treasuries bids up their prices and yields fall. When confidence returns, investors dump their bonds, thinking they do not need to play it safe. This causes bond prices to sink and yields to climb.

The US 10-year Treasury yield has more than doubled this year, starting 2022 at 1.65%. Source: MarketWatch

Although Treasuries were popular during the coronavirus crisis, with high demand pushing nominal yields into negative territory, as bond prices soared, Bloomberg reported on Oct. 10 that the biggest players in the $23.2 trillion US Treasury market are in retreat:

From Japanese pensions and life insurers to foreign governments and US commercial banks, where once they were lining up to get their hands on US government debt, most have now stepped away. And then of course there’s the Federal Reserve, which a few weeks ago upped the pace that it plans to offload [sell] Treasuries from its balance sheet to $60 billion a month.

Bloomberg notes that the high US dollar is having a negative impact on foreign US Treasury holdings, giving the example of Japan:

As the Fed has continued to boost rates to tame inflation in excess of 8%, Japan in September intervened to support its currency for the first time since 1998, raising speculation the country may need to actually start selling its hoard of Treasuries to further prop up the yen.



And it’s not just Japan. Countries around the world have been running down their foreign-exchange reserves to defend their currencies against the surging dollar in recent months.



In fact, emerging-market central banks have trimmed their stockpiles by $300 billion this year, International Monetary Fund data show.



That means limited demand at best from a group of price-insensitive investors that traditionally put about 60% or more of their reserves into US dollar investments.



Commercial banks are also bailing on T-bills, with demand from them dissipating as Fed tightening drains reserves out of the financial system.

A JPMorgan strategist was quoted saying that banks during the second quarter purchased the least amount of Treasuries since the final three months of 2020:

“The drop in bank demand has been stunning,” he noted. “As deposit growth has slowed sharply, this has reduced bank demand for Treasuries, particularly as the duration of their assets have extended sharply this year.”

Even Treasury Secretary Janet Yellen is fretting about a lack of adequate liquidity in Treasuries. Yellen notes that the supply of Treasury debt has climbed by about $7 trillion since the end of 2019, but large financial institutions haven’t stepped up as purchasers. The former Fed Chair was also quoted saying that the Federal Reserve now has a standing repurchase facility to provide a liquidity backstop to the Treasuries market; that “can be helpful.”

This meshes with a September article in Sprott Money, which predicts the Fed will buy “everything” when the proverbial shit hits the fan, and this will trigger the collapse of the dollar. In asking who is going to purchase all of the ballooning deficits and debt resulting from the influx of government spending to help consumers and businesses deal with inflation, author David Brady’s answer is central banks.

Brady notes that interest rate hikes are a way for central banks to reduce inflation, but printing money to pay for relief programs means more currency chasing fewer goods and services, i.e., inflation.

How will the government fund even bigger deficits? Issue more treasury debt. Again, who is going to buy the debt? Central banks, led by the Fed. The Fed will have to pivot sooner rather than later or the whole house of cards collapses. While the dollar will likely continue to rise against the sliding euro and yen, its days are numbered also. It may be the last to fall, but when it does, it will be brutal, imho.

Simply put, fiscal spending must be funded with more debt issuance, and the only major players left remaining to buy that debt is the central banks.

Emerging market distress

A Bloomberg article from last week states that rising interest rates are evoking fears of the mid-1990s IMF debt crisis.

Developing-world economies that borrowed heavily in dollars when interest rates were low, are according to the article now facing a huge surge in refinancing costs. The narrative is as follows:

In 1997 several Asian currencies collapsed and were forced into default. Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in 1993-96, then shot up beyond 180% during the worst of the crisis. The first country to default was Thailand; the crisis then spread to Indonesia and South Korea, both of which sought financial assistance from the International Monetary Fund.

As a result of the IMF crisis, for a time developing-world economies eschewed foreign debt, but over the past few years many such economies were lured by low interest rates into issuing debt in hard currencies, usually dollars or euros. According to Bloomberg data, in 2020 dollar and euro borrowing by EM sovereigns and corporate borrowers hit a record USD$747 billion. Bulgaria and Turkey are among countries with over half their debt in foreign currencies.

Now, sovereign dollar bonds from a third of countries within the Bloomberg EM Sovereign Debt Dollar Index, are trading with a spread of 1,000 basis points of more over US Treasuries — a generally considered metric of distress. For example, investors in Mongolia are demanding a premium of about 1,200 basis points over Treasuries, to holds its March 2024 dollar bond. This is around five times the level recorded a year ago.

A wave of defaults across developing nations would have major implications for the global economy, just as Asian debt contagion in 1997 spread to Russia and Latin America.

So long as the dollar is at a high level, this risk grows. Surging import costs from a strong dollar caused Mongolia’s hard currency reserves to shrink and debt has reportedly grown to almost 100% of GDP.

Meanwhile, 15 of 23 emerging-market currencies tracked by Bloomberg are down more than 10% this year, heaping pressure on governments at a time when energy bills are also rising. Developing-nation governments need to pay back or roll over about $350 billion in dollar- and euro-denominated bonds by the end of 2024, according to data compiled by Bloomberg.

De-dollarization

In the 1960s, French politician Valéry d’Estaing complained that the United States enjoyed an “exorbitant privilege” due to the dollar’s status as the world’s reserve currency. His point was well taken.

The US dollar is the most important unit of account for international trade, the main medium of exchange for settling international transactions, and the store of value for central banks.

Because of the dollar’s position, the US can borrow money cheaply, American companies can conveniently transact business using their own currency, and when there is geopolitical tension, central banks and investors buy US Treasuries, keeping the dollar high and the United States insulated from the conflict. A government that borrows in a foreign currency can go bankrupt; not so when it borrows from abroad in its own currency i.e. through foreign purchases of US Treasury bills.

Lately though, “de-dollarization” is being pursued by countries with agendas at odds with the US, including Russia, China, Saudi Arabia and Iran.

As the target of US economic sanctions (for annexing Crimea, interfering in its election, and now, invading Ukraine), Russia sees diversification from the dollar and into gold and other currencies, as a way of skirting trade restrictions.

For the first five months of this year, China’s Treasury holdings fell below $1 trillion, a 12-year low, with concerns about the risk of Russia-style sanctions possibly accelerating a long-term financial decoupling driven by political tensions, according to Nikkei Asia. The country sold US government debt for a seventh straight month in June, signaling that Beijing is trying to defend the yuan against the dollar, added Markets Insider.

A few years ago China came up with a new crude oil futures contract, priced in yuan and convertible into gold. The Shanghai-based contract allows oil exporters like Russia and Iran to dodge US sanctions against them by trading oil in yuan rather than US dollars.

Russia and China have both made moves to de-dollarize and set up new platforms for banking transactions outside of SWIFT that skirt US sanctions. The two nations share the same strategy of diversifying their…