Times Are Changing
For many years, Japan has been used as the ultimate example for why sovereign debt burdens no longer matter in our bold new era of modern monetary theory. This week, Robin Brooks of the Brookings Institute splashed cold water on that line of thinking. Brooks highlighted the inconvenient truth that while 10-year Japanese bond yields have spooked markets by spiking to 2.3%, the market-based inflation adjusted 10-year forward projections for yields have already surged to 4.6%. That’s a level that, this week, Brooks described as “unsustainable,” and signaling “a de facto debt crisis.”
Make no mistake, where the Japanese debt-based fiscal experiment goes, so goes the American debt-based fiscal experiment. Aside from outright nominal default, the likely policy prescription for a “de facto debt crisis” is running the economy hot to inflate the debt away while suppressing bond yields with some form of yield curve control. That would mean that, by design, bonds would get slaughtered on an inflation adjusted basis, the currency would lose massive amounts of purchasing power, and gold and other scarce hard assets with intrinsic value would be expected to gain purchasing power on a secular basis. In HAI’s view, we are already seeing those exact market dynamics develop. Unavoidable counter-trend corrections aside, we firmly expect those market dynamics to continue and accelerate on a secular basis.
Now, the major counter argument for a looming American debt crisis has been, essentially, American exceptionalism under the petrodollar system. The argument has been that, given the global system, the world’s insatiable demand for dollars as a necessity to buy dollar-denominated oil and commodities, and the world’s insatiable demand for treasury debt as a means to stash savings in the dollar-denominated global reserve asset, American debt would never run out of buyers.
That’s a fair argument, and an apt description of how the world worked under the petrodollar system, but we are no longer in Kansas anymore. In HAI’s view, history written a few short years from now will almost certainly refer to the petrodollar system in the past tense.
That means the warnings from the newly acknowledged Japanese debt crisis need be taken very seriously by investors in a U.S. debt system that’s already loosing structural buyers.
Again, that would mean that, by U.S. policy response imperative, U.S. bonds would get slaughtered on an inflation adjusted basis, the currency would lose massive amounts of purchasing power, and gold and other scarce hard assets with intrinsic value would be expected to gain purchasing power on a secular basis.
To date, this has all been unfolding slowly, but to paraphrase Hemingway on going broke, it happens slowly and then all at once. Signs abound that we’re now in the “all at once” phase.
In a 2013 Bloomberg article titled, “PBOC Says No Longer in China’s Interest to Increase Reserves,” China first announced that it was done buying U.S. treasuries on net.
China had put itself in a position to do this because it had begun finding workarounds to the petrodollar system. This allowed it to import marginal energy and commodity supplies in yuan, which structurally reduced China’s need for strategic dollar reserves.
As a result, China’s holdings of U.S. treasuries peaked between the 2011-13 period, and then, since the 2013 PBOC announcement, China’s holdings of U.S. treasuries have fallen by close to 50%.
China is now the de facto “factory of the world.” They export manufactured goods, they import energy and commodities, and on net they run the world’s largest trade surplus by orders of magnitude. As a result, what they are doing with that trade surplus in respect to their U.S. treasury dollar reserves is the best global proxy for the health of the petrodollar system – and it’s down 50% since 2013.
This week, according to a new Bloomberg article titled “China Urges Banks to Limit Holdings of US Treasuries, Citing Market Volatility,” China is now “urging” state banks to curb their treasury holdings as well.
In HAI’s view, this new push for Chinese banks to shun treasuries could certainly be a Chinese move to hasten its defense against a weaponized dollar and add pressure to the already precarious U.S. fiscal situation. It could be part of a private U.S./China deal for China to move away from U.S. dollar markets to help weaken the dollar versus the yuan (to help U.S. efforts to reindustrialize while, in exchange, the U.S. retreats from China’s sphere of influence in a manner consistent with the new “Donroe doctrine”). It also could be, and probably is, varying degrees of all the above.
But, in HAI’s view, it certainly is the latest confirmation of an acceleration in an already long-established trend toward de-dollarization for China and other BRICS countries in favor of China’s growing gold-based trade network.
Underscoring that takeaway, recall, virtually every global player (very much including the U.S.) two weeks ago at Davos openly admitted that the global monetary system as it had been structured for decades – is over.
This week, headline news added a very surprising wrinkle that exacerbated recent corrective pressure on precious metals prices.
On Thursday, a Bloomberg article titled, “Russia Memo Sees Return to Dollar System in Pitch Made for Trump” implied the possibility of a major Sandy Kofax style geopolitical curve ball to HAI’s core global de-dollarization thesis. That said, HAI is confident that curve ball is way out of the strike zone. We’re not swinging.
According to Bloomberg, “The Kremlin has set out proposals that could see Russia embrace the dollar again as part of a wide-ranging economic partnership with the Trump administration, according to an internal Russian document reviewed by Bloomberg.”
Bloomberg continued, “the proposal, which was circulated among senior Russian officials, provides previously unreported insight into Kremlin thinking and tactics at a moment when potential economic agreements between the US and Russia are being negotiated as a key plank of any future peace accord for Ukraine… At the heart of the offer is Russia’s return to the dollar settlement system, a move which would mean a stunning reversal of Kremlin policy.”
Again, regarding this Sandy Kofax-style curveball analogy, it’s way out of the strike zone, we’re not fooled, and we’re not swinging. In HAI’s view, the Bloomberg story strains credulity to the max. It’s the one single “Where’s Waldo” outlier piece of evidence hiding in an otherwise strikingly clear million-piece puzzle-picture. HAI can only speculate as to what the motives were for the publication of that article, but until substantial and credible further evidence can corroborate the re-dollarization narrative embedded within the Bloomberg story, it’s interpreted by HAI as complete misdirection, and frankly, complete malarky.
Strangely, the Bloomberg article itself seemed to undermine its own validity. As the article stated, “until now, finding alternatives to the dollar, rather than restoring links to the US-led system, has been a key goal for Russia as President Vladimir Putin sought to deepen his relationship with China. For that reason, western government officials familiar with the contents of the document said they think it is extremely unlikely that Putin would ultimately pursue a deal that runs counter to Beijing’s interests.”
Given all that we know, it seems exceptionally unlikely that Putin would suddenly ditch China (the country with which he is more ideologically aligned and with which his economy and military now depend), to go back to the dollar system (based on a depreciating asset) that tried to make Russia a vassal of the U.S., all while Russia, by most credible accounts, has largely defeated a U.S. sponsored NATO military defense of Ukraine against Russia, and while Russia’s long standing de-dollarization strategy (with gold as their primary reserve asset) has paid off so handsomely.
At the same time, given all that we know, it seems equally unlikely that the Trump Administration, which has repeatedly expressed a desire to move away from the post-1971 dollar system, will willingly go back to that same dollar reserve system that has structurally hollowed out the U.S. industrial base and left the U.S. military and economy critically dependent on Chinese goods and financing.
Furthermore, according to Friday’s TASS (Russian State owned news agency) article titled, “Bank of Russia not taking part in talks on return to dollar payments for exports,” it would seem that perhaps any enthusiasm toward an unlikely re-patching of the old post 1971-dollar based system may be more than a bit ahead of itself.
In HAI’s view, if there is any substance at all to the Russian re-dollarization report, it would almost certainly be referring to a potential willingness, under certain mutually beneficial terms, for Russia to reengage in dollar trade under the larger context of a new super sovereign neutral reserve asset system (very likely gold-based, in HAI’s view) advocated by U.S. Trade Representative Jamieson Greer a few weeks ago at Davos.
After all, as former U.S. Congressman Ron Paul said this week, “Gold has been universal international money for thousands of years for many reasons; primarily because no government can control or counterfeit it. Naturally, some governments hate these natural restrictions. They want to spend money without restraint; and want to counterfeit their way to world domination. Alas, the United States took the latter road after WWII. The dollar became a weapon used against the rest of the world (and United States citizens). Times are changing though…and fast!”
If we want to tighten Ron Paul’s point, we can distill down to JP Morgan’s famous quote, “gold is money, everything else is just credit.”
We’ve been living in an all-time historical anomaly. We’ve been living in the only fifty-year period (the post-1971 petrodollar system) in thousands of years of history where printed paper credit is considered money, and gold is considered an obsolete “pet rock” dollar denominated risk asset. But in HAI’s view, JP Morgan was and still is right, “gold is money, everything else is just credit,” and Ron Paul is right, that with regard to the historical petrodollar money anomaly, “times are changing…and fast.”
The current precious metals correction could stabilize at current levels or could have another near-term leg lower, especially if the broad market comes under pressure. That said, in HAI’s view, on an intermediate and longer-term time frame, this precious metals bull has much more upside yet to come.
Weekly performance: The S&P 500 was down (1.39%). Gold was up 1.47%, silver was off (1.00%), platinum was down (1.51%), and palladium was off (1.12%). The HUI gold miners index recovered by 8.03%. The IFRA iShares US Infrastructure ETF jumped 3.11%. Energy commodities were volatile and lower on the week. WTI crude oil was off (1.16%), while natural gas was off by (6.52%). The CRB Commodity Index dropped by (0.96%). Copper was off (1.60%). The Dow Jones US Specialty Real Estate Investment Trust Index jumped 7.38%. The Vanguard Utilities ETF also jumped by 7.02%. The dollar index was off (0.77%) to close the week at 96.88. The yield on the 10-yr U.S. Treasury was off 16.5 bps on the week closing at 4.052%.
Have a wonderful weekend!
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
