Article Critique: The Fed Pays a King’s Ransom to China

This is a typical essay by a gold bug.  He gets the conclusion correct, buy gold, but misses the nuances of the market.  This is why the gold community is always shocked when gold goes down, and decry market manipulation.  There are many forces at work, including the race to safety, and the effect of deleveraging.  Cash is king in those situations.

The Fed Pays a King’s Ransom to China

America’s economy is in shambles. Fiscal policy is totally gridlocked between Democrats who want to see some long term tax increases, and Republicans who only want spending cuts. Worse yet, the Republicans view economic failure in America as a good thing as they believe it will enhance their chances of recapturing the White House. Because compromise on the budget seems to be off the table right now, that leaves only the Federal Reserve policy to stimulate the economy. So, judging from what’s been reported in the financial press and on TV lately, the Fed’s policy is ringing loud and clear: Keep interest rates at record lows, and devalue the currency.

Keeping long term interest rates low is desired because the Obama Administration is praying that loan and mortgage refinancing will put more money into the pockets of corporations and individuals, giving them money to spend. A lower dollar is also desired to help boost exports. Selling more abroad is, for now, the only way to create more jobs. In other words, fiscal policy is frozen like a deer in the headlights and easy money is the only policy our government’s got. There is just one big problem with a policy of low interest rates and a weak currency.

Foreign central banks, led by China, currently hold $3.5 trillion dollars invested in US treasuries. China created goods that they sold to America for dollars but now we want to pay them nothing in interest and devalue their savings held in dollars.

The People’s Bank of China is the largest foreign holder of treasury bonds.  It owns 26% of the foreign held debt, at $1.2 trillion.

Indeed, it must be galling to the Chinese that we are treating them this way. (It’s ironic but we’re treating our retired savers in our own country this same way). Needless to say, China understands what’s going on and it has them more than a little pissed off. At some point, they could cut their losses and swap their horrible investment in paper dollars for tangible assets such as gold and other resources they need to employ, feed, clothe, and house their 1.3 billion citizens.

What losses?  Bond yields are at all time lows.  Owning bonds has been a very profitable investment.

As the US economy heads into recession/depression/armageddon, we will see lower and lower yields in the long end of the yield curve.

Chinese bureaucrats are not motivated by profit.  They are motivated by maintaining their power.

They are not hedge fund managers.  They do not make 2 & 20.  They are told by the communist party to buy US Treasury bonds, to continue mercantilism.  They are an export driven economy.  They do not want to lose their buyer.  They are happy to subsidize the American consumer.  They do this by buying the dollars from their exporters, printing Yuan to trade back to their exporters (thereby inflating their currency), and buying US government IOU’s with the excess dollars.  This helps to lower long term rates for the US government.

Countries holding US treasuries face a two pronged dilemma: First, if they dump longer term treasury securities, they would suffer massive price declines because selling long term notes and bonds pushes their prices down. Second, foreign countries would suffer currency depreciation losses because selling dollars pushes the dollar down. If China and other central banks all sold their longer dated treasury notes and bonds, US treasuries would decline in price, causing long term interest rates in America to soar. At this time in American history when our economy is so fragile and weak, rising long term interest rates could spell disaster for our economy.

Business does not borrow at the long term US treasury rate.  Even if they did, businesses are not hampered by lack of credit.  We have too much debt.

This is the Obama Administration’s greatest fear especially as we approach an election year, so they had to come up with a plan so foreigners dumping their longer term US treasuries wouldn’t hurt us. Since monetary policy is all we’ve got, the Fed was called in to fix the problem.

So what else could the Fed possibly do to keep our economy moving in the right direction? Why not go to the Chinese and promise to pay them a big fat premium on their current long term treasuries (that were purchased at much higher interest rates) and let them swap them into short term treasury bills and notes. Indeed, looking at the prices of US Treasury notes and bonds, most are trading at premiums of 10 to 15 percent for recent issues, and 50 percent or more for those issued just a few years ago. By allowing other countries to get out of longer term treasuries at a time of record low interest rates, it will give them an extraordinarily large gift and potentially enormous profits that can be used in several ways: China would likely use the profits to offset currency losses when the Fed goes back to printing money in QE3 to fund our deficit; and, in Europe, the profits could be used to help recapitalize their banks which are loaded up with Greek, Irish, Italian, and Spanish debt.

Bonds have been rallying for months, long before Operation Twist was announced.  They have been rallying because they are considered a safe haven by the world, not because the Fed is promising holders fat premiums.  Bonds are likely to continue to rally, because in a depression, long term yields fall.

When foreign countries have fewer treasury notes and bonds left in their arsenal to sell, when they do get around to selling their dollar holdings it’ll push the dollar down without pushing interest rates up. (Note: Short term treasuries will not go down in price if sold. Indeed, they can only go down if the Fed raises rates, and even then they quickly adjust back to a par price of 100.)

What?  Short term treasuries don’t respond to the market dynamics of supply and demand, while long term treasuries do?

At that point, America can dare China to sell the dollar, because pushing the dollar down is our policy.

So basically now you know what the Fed’s recent “Operation Twist” is all about (a more appropriate name might be “Operation Payoff”). We are paying a King’s Ransom to pave the way to devalue the dollar in the next QE3 and beyond. Just remember the downside of a falling dollar will be higher import prices and higher inflation.

If you would like to participate in Operation Payoff, do what the Central Banks will be doing: Sell your long term treasuries to the Fed and then brace for the next round of dollar devaluation and inflation which will soon be on the way.

Central Banks will not be selling their bonds, because it will raise their currency.  Even Switzerland is suppressing its currency vs. the Euro.  The central bankers of the world are Keynesians.  They believe in weak currency to promote exports.

Long rates were already falling. The yield curve has been flattening out. We are obviously headed for recession.

The real reason for the flat yield curve in the Operation Twist.  The real reason is  a looming recession.  The FOMC wants to take credit for it.

Why?  They want the market to see them as the cause for mortgage rates moving lower.  They are moving lower on their own.  Investors were already trying to lock in long term returns because they fear the economy will not be providing profits any time soon.  Now they will find more competition for yields from the FED.

Those who buy these low-interest bonds will get hammered when the FED inflates and long rates go back up.

And when the FED inflates, real assets will rally.

Real rates are at zero.  This cannot go on forever.  It exists because:

  • bankers are terrified and hold excess reserves with the central bank, they will not lend at these low rates with little cushion for counterparty risk.
  • investors cannot get positive rates of return in a slow economy that is headed towards recession.

Bankers and investors buy T-bonds.

China buys T-bonds to hold down the price of the yuan, for its export-driven mercantilism.


So, back to gold.

Gold is not an inflation hedge.  We had inflation during the 1980s and the 1990s.  Gold went down.

Gold is a crisis hedge.  When rich people are confused about the future of markets or currencies, they buy gold. Poorer people buy silver. Few Americans have bought either. Asians buy gold and silver. Arab Sheikhs buy gold.

Gold and silver are not deflation hedges. Cash is. In a major deflation (collapsing banks, no FDIC) currency is.  Even if it is fiat.

Gold and silver are good mass inflation hedges and hyperinflation hedges.  But the FED will stop printing before we suffer hyperinflation.

Gold holds its purchasing power over decades.

We are entering a time of crisis. Gold is better than silver. Both are better than fiat money. Buy the things you and others will need during high inflation, before inflation hits.  There is no tax on buying goods that appreciate, when you consume them.  This is the Alpha Strategy.

If a hurricane is coming, buy flashlights and batteries, not gold. Get out of town rather than buy gold.



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