Wednesday's trading provided an interesting illustration of how the dollar (and other markets) will move in the event of a crisis which could be precipitated if the huge amount of debt that the U.S. government needs to sell into the market should happen to meet with a decrease in demand.
Weaker demand was seen in a bond auction the government held yesterday and as a result, stocks, bonds and the dollar all fell against the euro. Usually, as has been well illustrated during the financial crisis, a decline in stocks leads to a gain in bonds and the dollar.
The indirect bid, demand from domestic and foreign institutions, including foreign central banks, for the $34 billion five-year Treasury note auction was 30%, compared to 48.9% from the previous auction in February and an average of 30.1% for the last 10 auctions.
The weak U.S. auction came after a sale of U.K. government debt on Thursday failed, the first failed auction of conventional U.K. government bonds since 1995. Like the U.S., the U.K. is hoping to sell a large quantity of new debt as it looks to stimulate its economy.
The Treasury is looking to sell a record $98 billion in securities this week and debt sales could triple to a record $2.5 trillion as the government seeks to fund President Obama's fiscal stimulus plans. The question is whether enough demand will be seen. If not, prices will fall and interest rates will rise, which would possibly cause stocks and the dollar to fall.
Aside from the concerns that America's biggest foreign creditor, the Chinese, expressed this week regarding the safety of U.S. debt, another factor is likely to come into play with regards for a potential decrease in Chinese demand for Treasuries. China now holds $739.6 billion of U.S. paper, which they bought as their reserve balance expanded this decade to over $2 trillion (by some estimates because China does not report its reserves to the IMF) due to the growth seen in their export sector, especially to the U.S.
The problem here is that Chinese demand for U.S. debt is likely to fall, and it can fall for reasons other than the fact they are nervous about their investment.
Because the global economy is declining, and could actually contract for the first time since WW II this year, Chinese exports, along with the rate of growth of their foreign currency reserves, are slowing, which means China will simply have less need to park their dollars by purchasing U.S. debt.
A trend for this is already developing when you look at the latest monthly report of foreign holders of Treasury securities, as China's demand for U.S. debt fell sharply in recent months.
Demand by China for U.S. paper grew by 10.65% from September to October 2008. That demand slowed to a 4.25% increase in November, a 1.99% increase in December and a just 1.61% increase in January.
The situation is by no means unique to the Chinese either. Other exporters, from the Japanese to the Brazilians to the Gulf States, are also in a similar position and some have actually decreased their holdings in recent months.
For example, Japan's exports have fallen nearly 50% over the past 12 months, as that nation faces the deepest recession among the major industrial powers. Japan is the second-largest foreign holder of U.S. debt with $634.8 billion worth, and their holdings grew by just 1.53% in the three months to January.
Demand from the oil exporters, the third-largest foreign holder of U.S. debt ($186.3 billion), declined by 0.48% over the same period. Demand from the Caribbean Banking Centers (fourth-largest holder with $176.6 billion) declined by 13.85%, Brazil (fifth-largest holder with $133.5 billion) declined by 1.91% and the U.K. (sixth-largest holder with $124.2 billion) fell by 6.19%.
Coming at a time when supply figures to greatly increase, less demand from China and other exporters will obviously lead to lower prices (and higher interest rates) on the debt the U.S. is offering, a situation which would be a huge negative for stocks and for the dollar. It will look like a crisis because stocks, the dollar and Treasury prices will decline at the same time, which happened on Wednesday afternoon when stocks and bonds declined as the dollar fell against the euro in reaction to the weaker demand seen in yesterday's Treasury auction.