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Foreign Central Bank Reserves Held at the Fed and France

(July 21, 2011)

Dear Subscribers and Readers,

Note that any deal on the “debt ceiling” between President Obama and the U.S. Congress will reduce the budget deficit.  As taxes are raised and government spending is curtailed, the U.S. current account deficit (now at around 3% of GDP), will shrink further—another spike in oil prices notwithstanding.  Moreover, as global liquidity continues to tighten and as more U.S. domestic supply comes online, oil prices are likely to decline in the second half of the year—thus further reducing the U.S. current account deficit.  The depressed value of the U.S. dollar (at least on a purchasing power parity basis) will also continue to reduce U.S. imports and increase exports.  Indeed, many U.S. manufacturers have or are considering relocating their operations back into the country

As discussed in our earlier commentaries, the decline in the U.S. current deficit is akin to reducing global liquidity—as most global trade is still transacted in U.S. dollars.  In other words, despite the advent of the Euro and the Chinese Renminbi, the U.S. dollar remains the “lubricant” for world trade.  Similar to a game of musical chairs, the “marginal” U.S. dollar borrower (e.g. Thailand in July 1997, Brazil in 1998, and Argentina in 2002) will be cut off due to a declining supply (or a decreasing growth in supply) of U.S. dollars—resulting in a liquidity squeeze in major parts of the world.  In such a scenario, the U.S. dollar and U.S. assets (e.g. Treasuries) would outperform.

One indicator/measure of a potential US$ liquidity squeeze is the growth in the amount of foreign central bank reserves (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve.  Whenever the rate of growth of foreign assets held at the Federal Reserve banks decreased substantially, the U.S. Dollar has almost always rallied—typically resulting in some kind of foreign financial crisis.  This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.   The following chart showing the level of foreign reserves vs. the annual change in foreign reserves (from January 1982 to June 2011):

Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard as opposed to the Gold Standard that has been in place since the end of World War I.  Therefore, as world trade expanded, the demand for dollar has continued to increase - and with it, the continuing increase of foreign dollar reserves held at the Federal Reserve Banks.  It is interesting to note that various financial crises or economic recessions (see above chart) have usually occurred when the annual change of dollar reserves is slowing down or experiencing negative growth.  This growth rate has been as high as 36% in August 2004 but it has been decreasing since the beginning of 2010.  In a world awash of liquidity since early 2003, it is unavoidable that there will be a misallocation of capital somewhere in the world.  One example is U.S. real estate during the mid-2000s; as well as the sovereign debt of the PIGS countries that are now coming home to roost.  As the U.S. current account deficit continues to improve, other crisis will inevitably pop up—and as such, the European sovereign debt crisis may get worse later this year.

As we mentioned in last weekend's commentary, we believe the Italian situation is salvageable, as it is more of a liquidity event, as opposed to a “solvency event.”  Italian debt yields have come down since earlier this week ahead of the results of a German-French meeting on the Greek debt crisis; however, subscribers should note that Italy have had a history of punishing foreign bondholders through inflation/devaluation of the Lira.  In other words, I still believe that betting on Italian debt is risky. French sovereign debt, however, is a different story.  While the French could not do much about its debt in the aftermath of World War II, it is to be noted that the French has a history of repaying its foreign debt holders.  Junius Morgan (father of JP Morgan) once stated that none of the 12 French governments since 1789 has ever defaulted on its debt when he decided to prop up the French bond market during the Paris Commune in 1871 (French bonds had fallen from 80 to 55).  In 1873, the French repaid its debt in full; and Junius Morgan made a fortune.  Compared to Italy, the French has had a history/culture of fulfilling its financial obligations.  From a political economic standpoint, I would thus purchase French sovereign debt if spreads French-German spreads continue to blow out.  We will update our subscribers as the situation continues to unfold.

Signing off,

Henry To, CFA, CAIA

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