Holding US assets is not as safe as it is thought to be since interest rates are artificially low, and the US dollar is artificially high as a result of the coordinated actions by central banks. The Bank of Japan’s and the European Central Bank’s monetary policies such as sub-zero interest rates and quantitative easing not only drive down yields, but it also drive up the price of the dollar and US Treasuries.
The strength of the dollar cannot be explained from the US trade balance nor the health of the American economy or the predicted worsening of the US deficit. Americans have been consuming more than they have been producing for decades. Such a comfort cannot last for ever: one of these days debtors (consumers) will have to pay back their creditors. When investors start to withdraw their investments from the US, the dollar will lose its value rapidly. Many have wrongly prophesied the demise of the dollar: it has not happened as yet, but that is not to say it never will.
US trade deficit is underestimated
The US Balance of Trade in Goods and Services seems to have been stable since 2010. Moreover, the data released by the US Census could lead to the conclusion that the US deficit in trade has even been slightly curbed for the last four years. Contrary to the general belief that an expensive currency will inhibit exports and increase imports, a high appreciation of the US dollar has not enlarged the US trade deficit in the short term. This is because foreigners are willing to deliver real products, like crude oil and Chinese-made consumer goods, in exchange for fewer printed dollars.
Though the US authorities can convince the financial markets that the trade deficit is under control, it is not. Let us see what could have happened if the exchange rate between USD and EUR had been fixed at the September 2014 level, just before the euro collapsed.
As can be seen, the US trade deficit from the American perspective differs from that of the European perspective. At the beginning of the period the gap between the US trade balance in dollars and euros was minor. If global accounting had then been done in euros, the US trade deficit would have been increasingly steady.
Global central banks keep the dollar strong
Theoretically, if a state has a permanent trade deficit and a floating currency regime, it has to constantly buy foreign currencies and to weaken its own currency, so that the imports can become more and more expensive (and the exports more and more beneficial), which means that in the long term the trade balance is reached. But economic rules do not apply to the US, whose dollar is the reserve currency. Washington can persevere with a deficit as long as other nations trust in the value of the dollar and are eager to buy US treasuries, hereby reinforcing the American currency.
The more money the global central banks deliver, the stronger the dollar is, because cheap yens or euros can enhance the American stock market or can be converted into trusted US bonds with higher yields than European or Japanese ones. European investors borrow in Europe and Japan free money, convert it to dollars and reinvest in the US, pushing the price of the dollar up. Since 2012 the US dollar appreciated against the euro, from 1.3 to 1.1 (roughly about 20%). Against the yen, the dollar rose from 77 in 2012 to 120 in 2015 (55%).
There are no signs that low-interest rates and QE have helped the European and Japanese economies to recover significantly. Therefore, the suspicion that monetary policies of central banks were coordinated to enhance the dollar’s value and the US economy seems to be justified. Now, when the ECB starts buying up corporate bonds, European companies can borrow money from the ECB at zero or negative rates to buy US treasuries, making a risk free 1.4% profit. If the central bank’s “music” stops playing, the dollar will depreciate, and the US trade deficit will increase dramatically. A weak dollar does not ameliorate the US balance as the superpower has too much constant costs like enormous import and military expenses outside the country.
The bubble in the bond market is the biggest in history, surpassing the 2008 housing bubble. Holding dollar-dominated bonds has become a speculative investment rather than a safe haven for a fixed income. If the FED increases interest rates to prevent dollar outflow, the opposite will happen, as we saw in February when the yen started to appreciate after the first FED’s rate hike. The newly issued debt will have a higher yield but the existing treasuries that are held by investors will deteriorate rapidly.
Carry trade instead of fundamentals
It is extremely worrisome that unconventional monetary policies pursued by the BoJ and the ECB drive the US trade deficit. European and Japanese producers can be satisfied that they export more and more commodities denominated in euros and yens. But at the same time, the European and Japanese investors have to lend more and more money to Americans (in terms of euros or yens) to finance the US trade deficit.
In absolute terms investors have out the most money in the US, a country that has an external debt of 19 trillion dollars. Speculators are borrowing cheap money from the ECB and BoJ to buy bonds in the US. The difference in interest rates provides traders with a risk-free income. This so-called carry trade has nothing to do with sound investments; still, it provides the US with enough euros and yens to spend in Europe and Japan. If this carry trade starts to unwind, investors will want to exchange their dollars for euros and yens to close their position as a result of which the dollar will depreciate rapidly. We are seeing this already happening with the Japanese yen as we warned of in February.
A constant trade deficit is not sustainable. If a population consumes more than it produces, it needs an inflow of foreign currencies in the form of investments or debts to level its balance of payments. The US net international investment position is -39% of GDP, more than 5 trillion dollars, which means that Americans are a debtor nation. By comparison, Japan has a high public debt but a net international investment position of +74.4%.
The US government debt is 105% and according to the congressional budget office projection the US deficit will rise steadily again in the coming years, further increasing the public debt.
Keep an eye on oil
The problems for the dollar will be even worse because the oil production in the US is collapsing. Since 2009 oil production has increased from 5 Mbd to nearly 10 Mbd (Million barrels per day). Now the oil industry in the US is crumbling and the production has declined to 8,5 Mbd, as we predicted in October.
The sharp drop in oil production will add to the US trade deficit. If the US oil production declines to 6 or 7 Mbd, the country will have to import another 3 or 4 Mbd at a price higher than 50 USD per barrel, which will increase the trade deficit even by 27% (if the oil price goes up by 50%) or by 44% (if the oil price doubles). In the years 2006-2008, when the oil price peaked at 140 dollars, the US trade deficit exceeded $700 bn.
It is not clear when the dollar will depreciate and foreign investors will see their US investments evaporate. However, we discern four key factors that can trigger such an event:
- Japan and Europe have aging populations, which by definition want to repatriate their savings and investments rather than supply the US with more credit.
- China will concentrate on its domestic consumption, and will reduce exports of cheap products to the West. The current yuan depreciation is driven by speculators and temporary capital outflow.
- The oil production in the USA is collapsing, the country will have to resume importing more oil from the Middle East, which will become more expensive.
- The ECB and BoJ monetary policies cannot last for ever, as unconventional policy cannot be an everlasting normality.
The current situation is economically unstable and cannot last forever. With the US’s public debt and budget deficit steady increasing, and the trade deficit ever growing plus a 5 trillion net debt position, the US dollar is a troubled currency.