Debt Ceiling Jeopardizes Dollar’s
Reserve Status
May 24, 2011 www.merkfunds.com/merk-perspective/insights/2011-05-24.html U.S. Treasury Secretary Geithner
has warned that delays in extending the U.S. debt ceiling may cause
irreparable harm. While borrowing costs for the U.S. government have not yet
risen, irreparable harm may have already been done to the U.S. dollar and its
status as a reserve currency. Ironically, it’s not a plunging, but a rallying
bond market that is a symptom of the problem. Let us explain.
First, no one really knows how the markets will
behave should the U.S. delay servicing its debt. Most observers believe that
a) the Treasury has a big bag of tricks to continue servicing the debt; and
b) politicians will play a game of chicken, but eventually do what they
always do: agree to spend more money. Some have even suggested that a
derailment of the bond market may not be the worst outcome, as it forces
action on the deficit now rather than later, arguing that in the long-run,
this would be a positive development. That said, we don’t know how the bond
market will react; but we do know that policy makers are playing with fire,
and when you play with fire, you may get burned. For the time being, there is a more imminent
problem building in the markets that may have long-lasting effects. At this
stage, the U.S. government may roll existing debt, but cannot issue new debt.
This has created a situation where fear may be spreading that there simply
won’t be a large enough supply of debt to meet investor demand. While this
sounds like an odd problem to have, we have recently witnessed a rather
unusual level of investment flows, with money piling into Treasuries. As of
this writing, investors receive a paltry 0.04% annualized return on their
money for giving Uncle Sam a 3-month loan. That’s a third of the yield
available at the beginning of the year, when 3 month U.S. Treasury Bills
yielded an annualized 0.12% (already a severely depressed yield):
For the time being, this is mostly an oddity. But
this may well have profound long-term implications for investors from
domestic institutions to foreign central banks. Our main concern, however, is with foreign
central banks. A key reason why the U.S. dollar has been the world’s reserve
currency is because of the lack of alternatives. And when we talk about a
lack of alternatives, we don’t talk quality, but liquidity. When you have
billions to deploy, but don’t want to rock the markets, the U.S. Treasury
markets have historically been the most liquid in the world. The People’s
Bank of China, for example, has been increasing its gold holdings; however,
as a percentage of its reserves, gold holdings have been going down as total
reserves have been climbing at an even faster pace. Liquidity concerns may be
the main driver behind this, as the gold market is far less liquid than the
Treasury markets. Like most central banks, the People’s Bank of China
typically does not try to influence market prices, thus adjusting any
involvement based on liquidity considerations. It’s not just the gold market, though. As far as
money markets are concerned, the U.S. has the deepest, most liquid market in
the world. Indeed, one of the best ways to increase global stability would be
for Asian countries to develop their domestic fixed income markets, so that
Asian issues of debt are less dependent on the U.S. dollar. But even the Eurozone with an active market in German and French
Treasuries, to name a few, is a distant second to the U.S. Our concern is that the building scarcity of Treasuries
will force central banks elsewhere to deploy their money outside of the U.S.
Treasury market. As foreign central banks gain operational experience in less
liquid markets, they may not revert back to U.S. Treasuries once the gridlock
on Congress is resolved. Note that central banks often buy longer dated
securities, but we use 3 month bills to illustrate the issue, as those bills
should not change all that much in value absent of a change in Federal
Reserve policy. Of course, if the scarcity of Treasuries were a result of
less deficit spending in the U.S., it would be an entirely different story.
But given that the U.S. depends on a vivid Treasury market for a seemingly
ever-escalating deficit, the implications of alienating large foreign investors
could be dire. In that context, it is worth noting that China has been
reducing its Treasury holdings rather steadily:
We are not predicting that institutional
investors will abandon the Treasury markets in the near future, but the
damage created by a failure to raise the debt limit can already be seen in
the markets. As investors, domestic and foreign, learn to deal with reduced
liquidity in the Treasury markets, they will have to deploy money elsewhere.
As such, foreign central banks may accelerate their diversification beyond
the U.S. dollar as operational experience is gained and liquidity may
increase in other markets. In the short-term, another driver may be that the
artificial shortage of Treasuries make their yields
unattractively low, thus encouraging rational investors to look elsewhere for
less manipulated returns.
Please join us for a Bloomberg Webinar on May 26 where we
will discuss the other side of the coin: the future of the euro in the
context of U.S. and Eurozone challenges (click here to register). To be updated as this discussion evolves, please
make sure you sign up to our newsletter. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk
Hard Currency Fund; transparent no-load currency mutual funds that do not
typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com. Manager of the Merk
Hard, Asian and Absolute Currency Funds, www.merkfunds.com Axel Merk, President
& CIO of Merk Investments, LLC, is an expert on
hard money, macro trends and international investing. He is considered an
authority on currencies. The Merk Hard Currency Fund
(MERKX) seeks to profit from a rise in hard currencies versus the U.S.
dollar. Hard currencies are currencies backed by sound monetary policy; sound
monetary policy focuses on price stability. The Merk Asian Currency Fund
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dollar. The Fund typically invests in a basket of Asian currencies that may
include, but are not limited to, the currencies of China, Hong Kong, Japan,
India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan
and Thailand. The Merk Absolute Return Currency
Fund (MABFX) seeks to generate positive absolute returns by investing in
currencies. The Fund is a pure-play on currencies, aiming to profit
regardless of the direction of the U.S. dollar or traditional asset classes. The Funds may be appropriate for you if you are
pursuing a long-term goal with a currency component to your portfolio; are
willing to tolerate the risks associated with investments in foreign
currencies; or are looking for a way to potentially mitigate downside risk in
or profit from a secular bear market. For more information on the Funds and
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and as such, changes in currency exchange rates will affect the value of what
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