A Tiger In Your Portfolio: The 'Debt Weapon'
by Daniel M. Ryan
by Daniel M. Ryan
Sometimes, even large markets can turn on a dime. We saw that recently in one of the largest markets in the world: the U.S. dollar. Less than two months ago, the trade-weighted U.S. dollar index was touching 70. As of last Friday, it got to almost 76. In about the same timeframe, the Euro has gone from about $1.60 US to about $1.41. Although the recent rally looks like a mere blip on the longest-range St. Louis Fed's chart, it was still enough to knock gold and silver, as well as oil, right out of bull-market-recovery mode. According to post-mortems, the greenback reversal's cause was co-ordinated central bank intervention — which included the central bank of China.
In a sense, this explanation is counter-intuitive. The U.S. dollar market nowadays is too large to control, even by a team of central banks. It's much larger than the gold market was as the'70s opened, and the co-ordinated team effort of the London Gold Pool didn't halt gold's rise back then. Central banks can't fight the fundamentals, as a certain government official found out in 1999.
Consequently, there's only one way that the recent intervention could have succeeded in its aim: it was well-timed. The U.S. dollar must have been sorely undervalued at that point, or at least deeply oversold. There's been a long learning process, but central bank officials are discovering that governmental force means little when compared with world supply and demand. They have to pay attention to fundamentals and timing just as any private-sector trading entity does, else their intervention is for naught.
This point is important, as it explains the most efficacious intervention undertook by a multi-government consortium in the last forty years. It's one that's remembered even to this day by Joe Average.
Freedom Hatred, And What To Do About It
The standard line as to the cause of 9/11 is President Bush's: "they hate us for our freedoms." Rather than mention such impolite terms as blowback, I'm going to take it straight by assuming that there's an evil genius called Useenhim bun Evil. He hates U.S. freedoms and has made it a holy cause to end what he considers to be the pernicious influence of the U.S. on the world. How would he go about hatching his plot? What strategy would he have?
Since Useenhim fears and loathes U.S. freedoms and their influence on the world, his obvious strategy is to bait the U.S. into ending them. A U.S. government that practices what it preaches makes bun Evil lose on the world stage. A U.S. government that continually acts hypocritically on the world stage makes bun Evil a winner. If the U.S. government abolishes at home those freedoms it ballyhoos abroad, then Useenhim wins. A pharisaical U.S. State is no threat to the kind of tyranny that bun Evil holds dear.
So, it's obviously in bun Evil's interest to goad the United States into becoming a police state, if not a military dictatorship. That's how Useenhim would win. Who amongst the peoples Useenhim holds dear would regard the U.S. government as anything other than an ignorable fraud should those same freedoms be eroded in the U.S. itself? The continual U.S. campaign for "human rights" would turn into little more than hot air.
More to the point, a U.S. of that sort would not be seen as a liberator anymore. That would make a war of "liberation" almost impossible to win. Baiting the U.S. government into eroding freedoms in the U.S. itself is the perfect Fourth Generation Warfare strategy. In addition to rendering any claims of "liberation" hollow in the invaded nation, it also creates a group of U.S. sympathizers at home — who sympathize for their own reasons. Case in point: a group of thirteen rebellious colonies, whose grievances touched a common chord amongst citizens of the Empire to which they belonged. "What they're doing to us, they're doing to you" makes for the kind of strategic alliance that requires no entangling treaty. Wild tales to that effect gaining widespread credibility is a sign that bun Evil's strategy is working for him.
Going On Offense
The above scenario is confined to defensive maneuvers. Within the confines of the "human rights" game, there is a way to go on offense — the "holier than thou" maneuver. We saw these offensive ploys during the Cold War: the U.S.S.R. became quite good at them. In the case of "radical Islam," the best tactic would be rigorous observance of certain civil liberties that haven't exactly been in a bull market these last seven years. This strategy, and others like it, goes with the flow. It doesn't create conditions; it works with already-existing conditions that have been "plausibly denied."
This go-with-the-flow aspect is also a feature of other means by which not-so-friendly foreign powers can get nasty with the U.S. That above-mentioned intervention, by a consortium of governments, was one of them. It was OPEC's use of the "oil weapon" in 1973.
We now know that this bolt from the blue was the result of the oil price failing to catch up with U.S. inflationist policies, leaving a huge equilibrium gap that OPEC could exploit. The price of other commodities, most particularly gold, had leapt up by a comparable amount in the early'70s. The oil weapon only worked because the U.S. practice of "exporting inflation" caught up with Americans.
Nowadays, there's no such inflation gap to be filled in the oil market. In addition, we've become inured to sharp rises in petroleum-product prices. These two changes suggest that, if the oil weapon is deployed nowadays, it would largely fizzle as a terror tactic. Another embargo would hurt, but it would not shock as it did back in 1973.
On the other hand, there is a continued equilibrium gap that would shock us if exploited. It's the "debt weapon."
To be more specific, it would be an embargo on holding and refinancing U.S. treasury debt. What makes this debt weapon so packed with a punch is the extraordinarily low interest rates the U.S. has enjoyed, relative to U.S. inflation. If you believe the official statistics, the U.S. government has been enjoying a recent negative-real-rate ride for about a year now. If John Williams' alternate measure is correct, then the U.S. government has been stiffing Treasury debtholders for at least three years. This gap can only go on for so long before it's filled.
The Tiger In The Tank
Although the total amount of foreign holdings of U.S. government debt seems eye-boggling, it's not overweening as compared with total U.S. treasury debt outstanding. What's most noticeable about the foreign-holders list is that the nation with the most is a long-time U.S. ally, Japan. Close in second is the People's Republic of China. The U.S. government, despite the continual China-bashing in the human-rights game, has little to fear from either of the two as of now. The nation that's #3 on the list is the U.K., a second long-time ally.
Fourth on the list is "oil exporters," a category that not only includes many Islamic countries but also several Latin American nations and a few African ones. Russia, #8 on the list, has only $65.3 billion in U.S. treasury securities. The oil-exporting nations, collectively, have only $170.4 billion. These two sums are only small fractions of the whole: even current Federal Reserve holdings of U.S. treasury debt make them look small by comparison.
Breaking down the securities by maturity reduces the alarm rate even further. The total amount of U.S. Treasury bills held by all non-U.S. governments — including the above-mentioned Japan, China and the U.K. — is a mere $225.8 billion. Looking at this total suggests that the debt weapon will prove to be a wet firecracker.
Markets, though, are made at the margin. If the U.S. government is getting an after-inflation free ride on the debt market, then all holders of its debt are somewhat asleep at the switch with respect to real yield. Many of them may have other reasons for investing in U.S. treasury securities, such as safety or convenience, which make the after-inflation yield not that relevant to them as of now.
If safety is the reason for this lassitude, then the safety premium has hit quite a high. The average interest rate of the entire U.S. debt, as of August 31st, is 3.902% for marketable securities and 4.827% for non-marketable securities; the total average interest cost is 4.36%. All of these numbers are well below the 12-month trailing official inflation rate, 5.6%. In other words, if the CPI figure is an accurate gauge of purchasing-power depreciation, the U.S. government has been enjoying an after-inflation free ride for all of its borrowings. Historically, this is an unusual benefit that doesn't last very long.
Given that the debt weapon would only carry a huge sting if the real rate of U.S. Treasury borrowings remains negative for quite some time, it's realistic to assume that it wouldn't be used for a few (if not several) years. The after-inflation free ride currently enjoyed by the U.S. treasury hasn't lasted sufficiently long for general complacency to set in. That complacency won't set in until the worried person who brings it up at parties becomes a well-known bore or laughingstock. We're not at that point yet.
In addition, as noted above, foreign holdings aren't that massive in comparison to the whole load. As also noted above, a mistimed use of the debt weapon will fizzle…just as the Gold Pool's interventions did.
Nevertheless, even a relatively small intervention can start an avalanche if the timing's right. It may only be a coincidence, a decision prompted solely by market fundamentals, but the Russian State has declined to renew most of its holdings in Fannie and Freddie debt. Despite official assurances that those shifts were not a dumping maneuver, it seems to have had the effect of one — although the Chinese State selling some of its own agency holdings seems to have been the final yell that started a pre-emption of an avalanche.
Despite its lack of imminence, though, the above-described "debt weapon" shows that the U.S. government has a lot to lose through throwing weight around on the world stage. What seems to be foreigners' gullship may turn out to be a prudent investment in geopolitical stability. We won't know until it's too late.
Thanks to last weekend's scramble, though, we do know that the People's Republic of China has the most noticeable creditors' clout. The PRC State has tended to be "businesslike" in its diplomacy so far…and not just with the United States.
September 9, 2008
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