2008 posed the largest threat to the system, and ended up in a bout of financial warfare between the US and its major competing trading partners. China and Russia, and middle-eastern countries saw the weakness within the US financial system due to excess liquidity, and tried to end the dollar standard in 2008. The US representatives in Washington had been used to such economic strength and superiority over all trading partners from the 2 decades of dollar stability that they became blinded to the risks of bad policy. They were unaware of the dangers of creating excess dollar liquidity within the world financial system. They had allowed the major competing trading partners to create huge reserves of dollar liquidity without a thought to the consequences of such actions. Washington began to legislate away financial system protection mechanisms, pushed the GSEâs to loan to low income Americans. The regulators turned a blind eye to US financial institutions who were hiring young mathematicians with no knowledge of financial history, or understanding of the dollar system, to create bad investment products in the name of innovation. These were a result of overconfidence, and the lack long term thinking. There were also geopolitical problems of terrorism and the aggressive foreign policy of a neo-conservative movement within the US government. US foreign policy became authoritarian and belligerent. These careless policies had to be paid for by increasing the world dollar supply exponentially. The US national debt increased 12 trillion in about 8 years. The massive amounts of treasuries issued would have created massive deflation, so the federal reserve had to create excess liquidity to accommodate the world economy. These very bad actions by the politicians in Washington set into motion an uncontrollable threat to the current debt/dollar based world financial system. There was too much liquidity sloshing through the world financial system, with massive amounts of dollar reserves sitting on the balance sheets of countries who oppose the dollar standard. These countries could not stop their large reserves from building to unmanageable proportions. China had such a huge trade surplus with the US, and recycled so many dollars into US treasuries and the GSEâs that the fed had lost control of the dollar markets when it began to tighten monetary policy in 2003. Alan Greenspan called the unresponsiveness of the treasury market a conundrum. The massive liquidity created from bad short-term policy in Washington had threatened the American way of life. The federal reserve members finally awoke to the dollar problem in 2005 when they contracted the money supply. It only slowed the US economy. They kept tightening the money supply aggressively, but the dollar markets stopped responding. The reserves of US trading partners were too large, the federal reserve lost control of its own dollar market. These miscalculations and paradigm shifts in the dollar markets, created a huge problem that the fed had created. They had contracted too tightly in the US and slowed the US economy without affecting any other economies in the world. In 2007 they got the final wake up call, of the shift in power in the dollar system. They had materially weakened the US economy. The policy makers didnât know at that moment how out of control they were of the their dollar system. Recognizing the mistake, the fed slashed short term interest rates aggressively in the second half of 2007 and started pumping liquidity into the system. US trading partners were overflowing with excess dollar reserves and started receiving this new excess liquidity due to their dollar pegs. They had too many dollars, but no place to recycle them within the US economy due to the weakness created by bad lending and fed policy tightening. These trading partners sensed this weakness as large amounts of excess liquidity began flowing onto their balance sheets. They decided, they wanted to protect their hard earned wealth and stop participating in the dollar recycling. By July of 2007, ironically, directly after the short sale uptick rule was removed by the SEC, the dollar system had become clogged. One of the last financial market protection mechanisms was removed, a symbol of Washingtonâs hubris. By January of 2008, as the US financial account contracted while the trade deficit increased, US financial institutions were on life support. The fed was pumping liquidity, but it wasnât enough. The removal of the uptick rule had opened and even inspired massive dollar holders the ability to short US equities via naked short selling. They found a new way to recycle their dollars. They would bet against US equities and buy commodities. It was a sure thing as these massive funds of dollars kept receiving more and more liquidity. The Federal Reserve had lost total control of the dollar system. They slashed and slashed rates, seeming to get a response from the equity markets, due to the massive short sellers from overseas being squeezed, but the credit markets did not respond. The Federal Reserve System was shooting blanks. In January 2008, Bear Sterns had taken huge losses on its mortgage backed securities as the securitization market collapsed. The buyers in the securitization market walked away in unison and left the investment banks holding the bag, while at the same time US bank liquidity was drying up due to the clog in international dollar recycling market and the result from the preceding tight fed policy that created an inverted yield curve. In 2008, congress passed a 152 billion stimulus that increased the limit on jumbo mortgages that the GSEâs could purchase to help stem the slide in housing prices. But it was too late. The US economy is analogous to a huge oil tanker, it takes a long time to turn it around. There were no international buyers of US mortgages. US banks even shunned the mortgage market, remembering what happened to Bear Sterns. The excess dollars created by the 152 billion was unable to help the US consumer due to dollar flight. As soon as the dollars landed in the hands of consumers, the liquidity from the last six months of fed easing was flowing into the coffers of excess dollar holders. They began buying crude oil and gold as if it were a currency, shunning each new dollar. The massive liquidity and out of control Federal Reserve created a crude oil superspike that sucked all the stimulus money out of the US economy and increased the US trade deficit further. This was a massive tax on the US economy, and quickly put the brakes on emerging economies. GM, the largest manufacturing company in the world began to collapse, signaling to US enemies that the US was vulnerable to attack and the end of the dollar standard was at hand. The summer of 2008 saw massive liquidation of US equities day after day, which began to put a drag on the world economy. The idea that the world economy had decoupled from the US economy had been disproven.
The Federal Reserve policy makers saw the end of the dollar coming quickly. They had one last option, I call the nuclear option. They started talking about moral hazard and too big to fail. They were hinting to the market that they were going to let a big one fall. By Septemeber of 2008, the world financial system was in total panic. The major US trading partners with massive dollar reserves got very nervous about this new policy shift by the Fed. There were threats from China and Russia that they were going to dump their treasuries if the Fed didn't bail them out of their losses in the GSE's. So, the fed policymakers gave in, knowing they were in checkmate. The fed nationalized the GSE's and took an 80% equity stake in them. Then came the Lehman collapse. This was their moment to act. The talk of moral hazard became louder. The Fed held a meeting with top bankers in the US and decided that they would use the nuclear option. They let Lehman collapse and allowed the financial system to freeze up, drying up dollar liquidity worldwide. Sunday night, the fed arranged a special session in the derivatives markets to allow European and US financial institutions to hedge all their losses in Lehman, knowing that Tuesday they would downgrade AIG in an excuse to take them over. AIG was used as a shell company to direct dollar flows to institutions of the Fed's choice. This allowed the fed to bypass the dollar recycling market and in essence created a separate financial system outside of the one that had collapsed. Massive injections of liquidity were made by the fed throughout september as currency swaps with central banks of their choosing.
Code: Government Bonds Japanese Government Bonds COUPON MATURITY DATE CURRENT PRICE/YIELD PRICE/YIELD CHANGE TIME 3-MONTH 0.000 09/07/2009 99.95 / .19 -0 / .003 22:00 6-MONTH 0.000 12/10/2009 99.9 / .19 -0.002 / .006 22:00 1-YEAR 0.700 05/15/2010 100.46 / .20 -0.019 / .017 22:00 2-YEAR 0.400 06/15/2011 100.02 / .39 -0.078 / .039 22:00 3-YEAR 1.400 03/20/2012 102.48 / .49 -0.128 / .044 22:00 4-YEAR 0.700 03/20/2013 100.13 / .66 -0.144 / .039 22:00 5-YEAR 0.800 03/20/2014 99.76 / .85 -0.238 / .052 22:00 6-YEAR 1.300 03/20/2015 101.83 / .96 -0.265 / .047 22:00 7-YEAR 2.000 06/20/2016 105.7 / 1.12 -0.245 / .035 22:00 8-YEAR 1.700 03/20/2017 103 / 1.28 -0.294 / .040 22:00 9-YEAR 1.300 03/20/2018 99.27 / 1.39 -0.124 / .016 22:05 10-YEAR 1.500 06/20/2019 99.76 / 1.53 -0.216 / .025 22:06 15-YEAR 1.900 03/20/2024 99.82 / 1.92 -0.104 / .009 22:02 20-YEAR 2.100 03/20/2029 99.1 / 2.16 -0.192 / .014 22:00 30-YEAR 2.300 03/20/2039 100.44 / 2.28 -0.09 / .005 22:02 Explain to me how inflation won't happen in Japan, yet it will happen in the US? Japan has debt to GDP going towards 200%, making the US look like Mother Theresa. Also, lately trade data has shown collapsing exports (which means savings rate is under hostage). I don't see fundamentals as that different. The Fed is in control, and is likely just playing chicken with the markets. Why? I say, Why not? These are government employees. Their motives aren't always obvious, nor even united. (ok, I know the Fed is private. But last time I checked, Bernanke is sitting in front of congressional committees getting a grilling on a regular basis. He's a public servant in my eyes).
Wow Pascal, that was one of the best group of posts in a thread ever on ET. Absolutely great analysis, seems spot on. Are you copying that from somewhere or writing it all yourself? Because if you are writing that yourself you need to write a book, your top-notch analysis and phrasing kept me reading every word. Please keep it coming, that was very worthwhile reading. I also would love to hear your opinion on buying commodities such as gold here?
Thank you, and yes this is all authored by me. I got inspired this weekend and wanted to post some of my thoughts to others here.
A hearty second! Thank you, that explained in 2,000 or so words what i've been trying to understand for 18 months. I was beginning to think ET was devolving into mostly hopeless drivel, but this post will keep me reading for at least another couple of months.
Hi Pascal, thanks for the analysis - I wish I had your understanding of the markets. I'm pretty sure that everybody here is dying to hear how did you learn all this stuff. Any book recommendations? Thanks for sharing.
This account sounds plausible at times, but that doesn't make it true. In my view, it's waaaay too simplistic of a summary and completely glosses over the complicated politics of the various relationships in Washington and arnd the world. The reality is really not that simple. Actions don't always result from people's conscious decisions. It's soooo much more complex.
Fantastic batch of posts, so elegantly formulated and corresponds well with my reading of the last couple of years. Bravo!
What I wrote was that there are possible scenarios where the Fed (or any CB for that matter) would lose control over its monetary policy, it is proved in theory and empirically. Is the US economy about to enter in this stage? I am not willing to answer this question but seems like you already have your opinion. By the way, in this recent interview - http://www.youtube.com/watch?v=Zhx-ywi9jB8 - Soros says that all lately money pump was necessary but eventually CBs will have to absorb back a certain level of liquidity, and I happen to think this is a sound argument.