China Plans To Limit Exposure to US Assets

China has begin the process of limiting their exposure to US assets, which will, ultimately, limit the ability of the United States government to continue to borrow to fund deficit spending. As a number of states, including but not limited to California and New Jersey, move towards requiring a federal bailout, there is high upward pressure on interest rates, and pressure for the value of the dollar to begin to oscillate, all of which points to a high potential for gold to thrive. See the following article from Expected Returns.

For those of us watching the ongoing economic saga unfold in horror, the eventual sell-off in U.S. assets is a given. The temporary lull in volatility in risky assets was merely a prelude to severe economic dislocations. Make no mistake about it: the U.S. will be faced with a major crisis- it's only a matter of time. From the UK Telegraph, China Orders Retreat From Risky Assets:

A Communist Party directive leaked to the Chinese-language edition of the Asia Times said dollar reserves should be limited to US Treasuries or agency mortgage debt such as Freddie Mac that enjoys Washington's implicit backing.

BNP Paribas said the move has major implications for global risk assets. "The message from Beijing is that we don't like this environment," said Hans Redeker, the bank's currency chief.

"When the world's biggest investor turns risk-averse, that is something you take notice of. We think this could become the new theme for the markets in the medium-term," he said.

The directive covers both the State Administration of Foreign Exchange (SAFE) and China's state-controlled commercial banks. Together they have an estimated $3 trillion (£1.9 trillion) of foreign holdings.

The exact break-down of China's holdings are a state secret but it is understood that SAFE bought large amounts of corporate debt as well as municipal and state bonds during the boom years of 2006 and 2007. Any move to liquidate holding of California debt at this crucial juncture could have serious implications.

While the developing debt crisis in Europe get all the headlines, U.S. states are imploding as we speak. The crisis in the state of California alone dwarfs that of any of the PIIGS, and the governor of New Jersey has just announced a fiscal emergency. It is pretty clear that states will have to be bailed out by the Federal government, which is why the move away from U.S debt is so important.

Given that the Federal government is literally broke, the only ways to bail out overburdened states are by borrowing or monetizing debt. Against a backdrop where most of the newly issued debt is directly monetized by the Fed, there is really only one direction for yields to go, and that's up. With a debt to GDP ratio approaching 100% in the U.S., any minor rise in yields equates to a huge increased burden in servicing costs.

Dollar Implications

David Bloom, head of currencies at HSBC, said the explosive dollar rally over the last six weeks has been the reversal of the dollar carry trade. "It has been short, sharp, and vicious. People borrowed in US dollars to invest in places like Brazil, Turkey, and New Zealand and now it is unwinding."

"We don't think the dollar rally is going to last much beyond the first quarter because we're in a new world of rotating sovereign crises where politics matters again. It's Greece right now but it could be the UK next, and then US which has yet to take any steps at all to tackle it fiscal deficit," he said.

The dollar is an obvious casualty here. Because yields in long-term U.S. government bonds are already near record lows, any minor drop in the dollar's value will dampen investor demand. Once momentum starts building on the downside, I expect a negative feedback loop to develop, which will result in dramatic swings in the dollar. It is worth repeating that there is only one asset I am sure will thrive in this environment, and that is gold.

This article has been republished from Moses Kim's blog, Expected Returns.