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Oil, the Yuan and the dollar-based monetary system

January 16, 2018

[This post is an excerpt from a commentary posted at TSI about two weeks ago]

Some commentators have made a big deal over the Yuan-denominated oil futures contract that will soon begin trading in Shanghai, but in terms of effect on the global currency market this appears to be a very small deal.

With or without a Yuan-denominated oil futures market there is nothing preventing the suppliers of oil to China from accepting payment in Yuan. In fact, some of the oil imported by China is already paid for in Yuan. Having a Yuan-denominated oil futures contract may encourage some additional oil trading to be done in China’s currency because it would enable suppliers to reduce their risk via hedging, but the main issue is that the Yuan is not a useful currency outside China. Unless an international oil exporter was interested in making a large investment in China, getting paid in Yuan would create a problem of what to do with the Yuan.

In any case, the monetary value of the world’s daily oil consumption is less than 0.1% of daily trading volume on the foreign exchange market, and the foreign exchange market is dominated by the US$. Despite the popular (in some quarters) notion that the US$ is in danger of losing its leading role within the monetary system, at last count the US$ was on one side of 88% of all international transactions. The euro, the world’s other senior fiat currency, was at around 30% (and falling). The Yuan’s share of the global currency market is very small (less than 3%), and according to the following chart could be in a declining trend.

The point we were trying to make in the above paragraph is that a change in how any country pays for its oil imports will not have a big effect on the global currency market. Actually, the cause-effect works the other way around. The pricing of oil in US dollars is not, or at least is no longer, even a small part of the reason that the US$ dominates the global currency system, but the fact that the US$ dominates the global currency system causes most international oil exporters to demand payment in US dollars.

The US$ sometimes rises and sometimes falls in value relative to other currencies, but it always dominates global money flows. Like it or not, that’s the nature of today’s monetary system.

The current monetary system is US$-based and in all likelihood will remain so until it collapses and gets replaced by something different. In other words, it’s unlikely — we almost would go as far as to say impossible — for the current system to persist while another currency gradually superseded the US$. The reason is that there is no viable alternative to the US$ among today’s other major fiat currencies.

We don’t have a strong opinion on what the post-collapse “something different” will be. One possibility is a system based on gold, but there could also be an attempt to create a global fiat currency. The world’s political leadership and financial establishment would certainly favour the latter possibility, but we fail to see how it could work as it would essentially be the botched euro experiment on a much grander scale.

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A reality check regarding China purchases of US debt

January 12, 2018

1. According to news reports, unnamed senior government officials in China have recommended slowing or halting the purchase of US Treasury securities.

2. If China’s government really was planning to reduce its investment or rate of investment in US government debt, why would it announce the change beforehand given that doing so would potentially lower the market value of its holdings?

3. The only reason to make the announcement is if there is no intention to implement a change but there is something to be gained by making the threat.

4. Clearly, the announcement is part of a negotiation strategy regarding China-US trade.

5. The reality is that China’s government buys and sells Treasury securities and other international reserve assets as part of its effort to manage (that is, manipulate) the Yuan’s exchange rate. When the Yuan is strengthening, international reserves will be bought — using newly-created local currency — to slow or stop the advance. When the Yuan is weakening, international reserves will be sold to slow the decline. That’s why China’s stash of US Treasury debt trended upward for many years prior to 2014 (when the Yuan was strengthening relative to the US$), trended downward during 2014-2016 (when the Yuan was weakening relative to the US$), and trended upward over the past 12 months (when the Yuan was strengthening relative to the US$).

6. China’s total investment in US Treasury securities was significantly greater 4 years ago than it is today. This is evidenced by the following chart, which shows that the combined Treasury holdings of China and Belgium (Belgium must be added to get the complete picture because that’s where China’s government keeps its custodial accounts) dropped from about 1.65 trillion in early-2014 to 1.2 trillion in May-2017. It’s likely that the holding is now about $100B larger, which implies that China’s government has been a net seller of about $350B of Treasury debt over the past four years.


7. China’s government will continue to do what it has been doing — buy US Treasury debt when it feels the need to weaken the Yuan and sell US Treasury debt when it feels the need to strengthen/support the Yuan.

8. There are good reasons to expect that yields on US T-Bonds and T-Notes will be significantly higher in 6 months’ time, but the recent deliberately-misleading news emanating from China is not one of them.

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Monetary Policy Madness?

January 8, 2018

In a recent newsletter John Mauldin wrote: “It is monetary policy madness to raise rates and undertake quantitative tightening at the same time.” However, this is exactly what the Fed plans to do in 2018. Has the Fed gone mad?

If mad is defined as diverging in an irrational way from normal practice then the answer to the above question is no. The Fed is following the same rule book it has always followed.

It should first be understood that earlier rate-hiking campaigns were always accompanied by quantitative tightening (QT). Otherwise, how could the Fed have caused its targeted interest rate (the Fed Funds rate) to rise? The Fed is powerful, but not powerful enough to command the interest rate to perform in a certain way. Instead, it has always manipulated the rate upward by reducing the supply of reserves to the banking system via a process that also reduces the money supply within the economy; that is, via QT. In other words, far from there being something unusual about the Fed simultaneously raising rates and undertaking QT, it is standard procedure.

What’s unusual about the current cycle is the scale. Having created orders of magnitude more money and bank reserves than normal during the easing part of the cycle the Fed must now implement QT on a much larger scale than ever before. At least, that’s what the Fed must do if it follows its rule book.

A plausible argument can be made that the Fed should now deviate from its rule book, but the argument isn’t that the economy is too weak to cope with tighter monetary policy. The correct argument is that the damage in the form of misdirected investment and resource wastage was done by the earlier quantitative easing (QE) programs and this damage cannot be undone or even mitigated by deflating the money supply. In effect, the incredibly loose monetary policy of 2008-2014 has made a painful economic denouement inevitable. At this point, reducing the money supply — as opposed to stopping the inflation of the money supply, which would be beneficial as it would prevent new mal-investment from being added to the pile — would exacerbate the pain for no good reason.

In other words, the damage done by monetary inflation cannot be subsequently undone by monetary deflation.

A plausible argument can also be made that for the first time ever the Fed now has the option of hiking interest rates without doing any QT. This is due to its ability to pay interest on bank reserves. This ability was acquired about 9 years ago solely for the purpose of enabling the Fed to hike its targeted interest rate while leaving the banking system inundated with “excess reserves” (refer to my March-2015 blog post for more detail). That is, this ability was acquired so that the Fed would not be forced to undertake QT at the same time as it was hiking rates.

However, the Fed is not going to deviate from its rule book. This is mainly because the Fed’s leadership believes that a new QE program will be required in the future.

To explain, a Fed decision not to implement QT would create an expectations-management problem in the future. Specifically, an announcement by the Fed that it was going to maintain its balance sheet at the current bloated level would be a tacit admission that QE involved a permanent addition to the money supply rather than a temporary exchange of money for securities. If the Fed were to admit this then the next time a QE program was announced there would be a surge in inflation expectations.

There has been monetary policy madness in spades over the past two decades, but within this context there is nothing especially mad about the Fed’s plan to raise rates and undertake quantitative tightening at the same time.

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You can bet on the continuing popularity of superficial economics

January 1, 2018

It is appropriate to think of Keynesian economics as superficial economics*, because this school of thought generally considers what’s seen and ignores what’s unseen. To put it another way, Keynesianism focuses on the readily-observable situation and the immediate/direct effects of a policy while paying little or no attention to why the current situation came about and the indirect (not immediately obvious) consequences of a policy. This leads to nonsensical conclusions, such as that the economy can sometimes be helped by the destruction of wealth (the idea being that after assets are destroyed people can be ‘gainfully’ employed rebuilding them).

To further explain, when a shop window is broken the typical Keynesian would account for the additional work and income of the glazier hired to fix the window but would make no effort to understand how the shopkeeper would have allocated his scarce resources if his window had remained intact. And in a case where resources are ‘idle’, the Keynesian would focus exclusively on the direct effect of using increased government spending or central bank money-printing to put these resources to work. He would pay scant attention to why the resources were idle in the first place and would ignore the longer-term effects of creating artificial demand for some resources and forcing the private sector to fund projects that it would otherwise choose not to fund**.

Due to its shallow nature, Keynesian economics is not useful when attempting to understand the real-world drivers of production and consumption. However, it can be put to good use when attempting to understand and predict the actions of policy-makers.

Aside from the fact that almost all politicians are economically illiterate, if your overriding goal is to win the next election then what you want are policy-related effects that are short-term, obvious and direct. What you want is to be able to point to a bunch of guys in hard hats hammering away on a government-funded project, and say: “Without the bill I sponsored, these guys would not have jobs”. The longer-term economic negatives aren’t relevant because not one voter in a thousand will see the link between these negatives and the “stimulus” bill.

There will come a day when Keynesian economics has been totally discredited again***, but until that day there will be many opportunities to make money by betting on policy-makers acting stupidly.

    *In a blog post in May-2015 I suggested that Keynesian Economics should be renamed ASS (Ad-hoc, Superficial and Shortsighted) Economics.

    **The “idle resources” fallacy that underlies the justifications for various government stimulus programs was debunked by William Hutt in a book published way back in 1939 and was more more briefly — but still thoroughly — debunked by Robert Murphy in a January-2009 article.

    ***Keynesian economics was discredited during the 1970s but subsequently managed to claw its way back to a position of great influence. It is resilient because it seemingly gives politicians the scientific justification for doing what they already want to do, which is make themselves appear benevolent — and thus garner the support of more than 50% of the voters — by spending the money of some people to provide short-term benefits to other people.

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