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"As the issuer of the world's reserve currency, the U.S. economy has for decades enjoyed the capacity to inflate dollar denominated securities at will. Our competitive advantage in issuing top-rated and liquid securities has served us especially well over the past decade. It was a key facet of “reliquefications” and “reflations” during periods of economic weakness and/or fledgling financial crisis. The much trumpeted “resiliency” of the U.S. economy and banking system owes almost everything to the capacity for the U.S. government and financial sector to endlessly create debt instruments readily accumulated by domestic and foreign holders. And I believe a strong case can be made today that long-term yields would be significantly higher if it weren't for the perception that the Bernanke Fed will aggressively cut rates at the first indication that the U.S. economic Bubble and/or Global Asset Market Bubble are beginning to falter. The blundering Fed apparently not only believes that the U.S. economy is more resilient than in the past, it presumes it now has significant leeway to cut rates and “reflate” when necessary.

But the financial world is changing rapidly and radically. The dollar is methodically losing its status as a stable and reliable reserve currency. At the same time, currencies generally are losing favor to real assets as store of value. Understandably, market participants are questioning the will and capacity for central bankers and policymakers to stabilize the Unwieldy Global Credit system. It would at this point require a determined and concerted effort to instigate some serious financial and economic restraint, especially among American, Chinese and Japanese authorities. No one would dare hold their breath waiting for this outcome.

With faith in the prospects for the dollar and global currencies in retreat, the U.S. is in the process of losing its invaluable competitive advantage issuing top-rated liquid securities. This has huge ramifications come the next period of financial dislocation. The Fed's intent to aggressively cut rates and incite yet another bout of lending and leveraged speculation (Credit Inflation) will likely be obstructed by the unwillingness of foreigners to accumulate more dollar IOUs. In the meantime, I believe the changing global landscape will necessitate that that the U.S. now pays an ongoing significant yield differential. Rampant liquidity and speculative excesses demand that global rates rise across the board, while the stability of the dollar depends upon the Fed's willingness to maintain significant rate differentials. Our foreign creditors will demand higher rates and much tighter monetary conditions, and the Fed's dream of wrapping things up before it gets painful faces the reality that our creditors are increasingly tired of getting hurt.

This week, markets began to demonstrate many of the characteristics one would expect when approaching a key inflection point. There was heightened volatility, spectacular short-squeezes, and palpable euphoria. But there are also indications that the “smart money” is increasingly nervous and beginning to lighten up on some positions (including our currency). It is amazing how many have completely bought into The Notion of a Golden Age of Permanent Global Prosperity; that the omnipotent Fed has everything completely under control; and that surging energy and commodity prices are a sign of how wonderfully healthy the global economy is these day (ignoring that we are instead immersed in history's greatest Credit and Asset Bubbles). One should now be on guard for that exacting oscillation between “gee, things are just marvelously splendid” and the “oh my god, the end is near” – The Unpredictable Greed and Fear Seesaw – that will embroil global markets in an extraordinary period of uncertainty and volatility.


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