Spring Migration

Migratory BirdsBy the first half of 2006, before the Federal Reserve had even stopped raising interest rates, economists were beginning to recognize where things could very well be headed: monetary policy easing, forced by a slowing economy and tightening credit, would both put downward pressure on the dollar (which already had resumed its decline by the end of 2005) and cause yields on U.S. Treasury bonds to plummet. The inflation risk was obvious to any educated consumer watching the news, but what some economists and analysts were also starting to consider was the possibility of a U.S. dollar end-game – foreign governments and institutions unwinding their dollar investments. The majority of experts dismissed the idea, arguing that investors couldn’t shun the dollar, because they’d be shooting themselves in the foot by causing their huge dollar-denominated holdings to lose even more value.

Fast-forward to this week. Despite sporadic reports that China was cutting back investment of its foreign reserves in U.S. Treasuries and other dollar-denominated assets, the media had pretty much lost interest in the story and was keeping its myopic focus on the housing crisis, the credit crunch, and the Bear Stearns failure. Then on Wednesday, an article in the Financial Times confirmed that migration of foreign funds out of the dollar is real and spreading.

The Times reported that South Korea’s National Pension Service – the fifth largest pension fund in the world – “will no longer buy U.S. Treasuries because yields are too low.” The story quotes an NPS spokesperson:

“It is difficult to buy more US Treasuries because the portion of our Treasury investment is already too big and Treasury yields have fallen a lot,” said Kwag Dae-hwan, head of global investments at the NPS. “We need to diversify our portfolio away from US Treasuries and we find asset-backed securities and corporate debt more attractive because of wider credit spreads.”

This is a very big fund, but surely one institution in one country does not a trend make. True. But the very next day, another Financial Times story revealed that Chinese exporters are moving away from the dollar:

According to Alibaba.com, the online company that matches Chinese suppliers with international buyers, the vast majority of their almost 700,000 Chinese suppliers no longer use dollars to settle non-US transactions to minimise foreign exchange risk.

“They are moving to euros, pounds, Australian dollars or even quoting prices in renminbi,” David Wei, chief executive, told the Financial Times. Moreover, he added, prices quoted in dollars were now often valid for just seven days compared with the 30-60 days common previously.

And there also was this item from Bloomberg earlier in the week:

Asian Central Banks Look to Invest Reserves in Region

By Arijit Ghosh and Aloysius Unditu

March 24 (Bloomberg) — Central banks from 16 Asian nations may invest more of their $1 trillion of foreign reserves in the region’s debt as Federal Reserve interest-rate cuts reduce returns on U.S. assets.

“This is something that most of us, that are not yet investing in, will be looking at,” Bangko Sentral ng Pilipinas Governor Amando Tetangco said in a March 23 interview in Jakarta. There can be “some kind of shift” to Asian sovereign bonds, Central Bank of Sri Lanka Governor Ajith Nivard Cabraal said in a separate interview on March 22, after a weekend meeting of policy makers from the region.

What happens if this trend continues? A sell-off in U.S. Treasuries would cause market interest rates to rise, despite whatever the Federal Funds target rate may be. Rising interest rates would make it tough for the economy to start growing again. At that point, all those assurances we were given that the recession would be “short and shallow” would fly out the window.

[tags] Fed, Treasuries, interest rates, credit, recession, stock market [/tags]

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