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The Trade Deficit Dilemma That's Alive and Well

So the Fed is doing exactly as expected, but the anticipation was much more fun than the reality. After rallying for weeks on ‘hopes’ of ever greater QE, last night US markets turned down. Exactly the same thing happened back in September when traders and computer algorithms alike hung precipitously of Bernanke’s words…only to lose their grip hours later.

The chart below highlights two recent and highly anticipated Fed statements. In mid-September, the market anticipated QE3 and rallied strongly into the lead-up. That spike you see was the intra-day high on the day of the Fed statement. The market subsequently tanked.

Then, with the S&P500 sinking through the all-important 200-day moving average in November, rumours began that the Fed would up their purchases of Treasury bonds: QE3.1.

Instead, Bernanke babbled on about targeting the unemployment rate…like that’s going to fix things. Again, men and machines rushed in ahead of the Fed statement (see second spike) only to run the other way after reality sank in. And they continued running overnight.

We think the market’s in the process of topping out. It’s a long, painful and drawn-out process, but the pattern should become a little clearer in the new year.

$SPX S&P Large Cap Index
Click here to enlarge
Source: StockCharts

So the Fed is doing exactly as expected, but the anticipation was much more fun than the reality. After rallying for weeks on ‘hopes’ of ever greater QE, last night US markets turned down. Exactly the same thing happened back in September when traders and computer algorithms alike hung precipitously of Bernanke’s words…only to lose their grip hours later.

The chart below highlights two recent and highly anticipated Fed statements. In mid-September, the market anticipated QEIII and rallied strongly into the lead-up. That spike you see was the intra-day high on the day of the Fed statement. The market subsequently tanked.

Then, with the S&P500 sinking through the all-important 200-day moving average in November, rumours began that the Fed would up their purchases of Treasury bonds: QEIII.1.

Instead, Bernanke babbled on about targeting the unemployment rate…like that’s going to fix things. Again, men and machines rushed in ahead of the Fed statement (see second spike) only to run the other way after reality sank in. And they continued running overnight.

We think the market’s in the process of topping out. It’s a long, painful and drawn-out process, but the pattern should become a little clearer in the new year.

$SPX S&P Large Cap Index
Click here to enlarge
Source: StockCharts

But we don’t intend to talk about the market today. It does what it wants and makes us all look like fools…especially the bears (like us) at this time.

Instead, we wanted to delve into another reason for the Fed’s actions. That is, it’s purely to prop up the international dollar reserve system. If that breaks down, the whole edifice tumbles, and we’ll all be in a spot of bother.

That sounds like a big claim, so let us try and explain what we mean.

As you probably know, the current system of international finance revolves around the US dollar being the world’s reserve asset. It’s a dual role currency. It has both a domestic and an international function. These roles are incompatible with each other, as highlighted by the economist Robert Triffen back in the 1960s…his work become known as the Triffen Dilemma.

In short, this dilemma states that the international function of the dollar is to provide the world with liquidity by running constant trade deficits. The US trade deficit (of real goods and services) shows up on the monetary side of things as US government debt piling up in central bank vaults of the surplus producing countries.

But a successful carrying out of the dollars’ international function also (slowly) undermines its effectiveness as a domestic currency. People want out of dollars and will buy other assets instead.

Triffen’s Dilemma is alive and well. We were reminded of this after checking out the US trade data for October, released a few days ago. The US ‘produced’ (we use the term loosely) a trade deficit of $42.2 billion for the month of October, up slightly from September’s $40.3 billion deficit.

The deficit is entirely in ‘goods’ as the US runs a slight ‘services’ surplus. In October, the US ran a small goods surplus with a handful of countries, including Hong Kong $1.9 billion, Australia $1.8 and Singapore $0.5. But that’s peanuts compared to the deficits it runs with its major trading partners.

The US recorded monthly trade deficits with China of $29.5 billion, the European Union $10.6, OPEC (major oil exporting countries) $8.6 and Japan $7.0. The year-to-date deficits give you a better idea of the size of the problem: China ($261.6 billion) the EU ($103.1 billion) OPEC ($88.9 bill) and Japan ($64.4 billion)

So these countries export their goods and the US sends them paper in return. But there’s increasing evidence the rest of the world is not so interested in US paper anymore. China stopped buying Treasuries in 2011. So did Germany, and OPEC has slowed right down too. All are buying less than their trade deficits.

We’re not sure what’s balancing the trade. Are they buying mortgage backed securities, or some other form of financial claim? We’ll have to dig around a bit more to find that out.

But when you view things from this context, it makes the Fed’s actions to buy $45 billion per month in long term Treasury securities much clearer. $45 billion per month should cover the trade deficits, right?

Maybe, but it won’t cover the government’s out of control spending. Marketwatch reports the US government ran a budget deficit of $172 billion in November. For the first two months of the fiscal year, the deficit came in at an eye-watering $292 billion.

Who is buying all this debt if not foreigners? The banks…pension and money market funds? The Fed’s ‘Flow of Funds’ report for the December quarter will give us the answers, but that’s still a few months away.

In the meantime, where do you hide? Bonds and equities are overvalued in a system facing a systemic breakdown. What about real estate? Australian residential property remains one of the world’s most expensive markets. Buying high is not generally a great wealth preserver.

Gold, the wealth preserver throughout the ages, is the logical asset of choice. But looks can be deceiving. The paper gold price is under pressure again, right when the rational explanation is that gold should be increasing in price (due to the explosion of US debt and the unsustainable nature of the US-dollar based financial system).

What makes us particularly suspicious is that the Bank of England wheeled out the Queen to inspect the gold held in their vaults. Is such a display meant to assuage people’s concerns about the viability of the British financial system (and the US’ largest ally in maintaining the status quo)?

Don’t be fooled…it’s not business-as-usual at all. The international system of finance that has prevailed since 1971 is coming apart. First it happens slowly, imperceptibly. And then it just breaks.

Regards,

Greg Canavan
for The Daily Reckoning Australia

From the Archives…

Will Lower Interest Rates Impact Australia in 2013?
7-12-2012 – Greg Canavan

Is the Australian Economy in Recession?
6-12-2012 – Greg Canavan

US Debt: Why America May Need a Bail Out by the IMF
5-12-2012 – Bill Bonner

If Profits are Falling Why are Stocks Rising?
4-12-2012 – Dan Denning

The Frontier Way
3-12-2012 – Dan Denning

3 Comments

  1. Ross says:

    US is now buying 70% of its USTs. Denninger actually thinks they plan to sell down assets on the Fed’s balance sheet… There is no way that will work as he explains to himself inside his fortress usa prism.
    http://market-ticker.org/akcs-www?post=214886
    The only way that would be planned given the full picture is a melt down. A liquidation in the Andrew Mellon style. Better do it soon while you still have the guns in working order to defend your borders and keep internal order after rushing home.

  2. Ronnie Bell says:

    OLD JEWS.
    I have been reading about the ancient Jews financial system. After7 years all debt was forgiven and everyone started out fresh. So if you lent money you made sure it got paid back within 7 years.
    Reading about US debt the figures never seem to line up in a row. 25billion 85billion and something called Trillion.
    What if we applied old Jewish wisdom and cancelled everyone’s debt at once.
    The Big Slam.
    A box of fried chicken for 25cents under the new dollar….backed by gold and the Fed building bulldozed. Fried chicken at 25 cents would make the sit down people quite happy.
    Everyone owns their own home. Or rental investments.
    All US manufacturing returned to the US or a 75% greed tax.
    And the nation lives within its means.

  3. Lachlan says:

    “Fed building bulldozed”

    Imo Ronnie that part of your idea is precisely the idea that the worlds financiers are going to attempt to front run just as they always have. Blow up a system and provide a new and better solution. The Fed is doomed. Their control possibly not. They would seem very ambitious but how many market collapses have they survived to date. This is who they are, what they do.
    Until then enjoy the Benny and the Inkjets spectacle. Everybody is allowed to poke fun.

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