Gold and silver prices notched strong gains yesterday as hedge funds flooded back into “risk” trades. Stock markets all over the world recorded gains, with commodities also joining the party – crude oil prices rose by 2.9%. The euro surged against the US dollar on hopes that Sarkozy and Merkel are serious about a rescue plan for the eurozone by the end of the month, with the Dollar Index losing 1.56% and settling at 77.49. US Treasuries also suffered losses as a result of the flight from “safe” assets.
It seems we have returned to that familiar pattern whereby Treasuries and the dollar sell-off on the slightest hint of good news, only to be immediately bought again on signs of economic problems. The $10 trillion question remains whether or not this correlation will hold, given the record rate at which foreign central banks (FCBs) are now dumping Treasuries. As Lee Adler writes over at The Wall Street Examiner, FCBs’ dumping of Treasuries and Agencies reached record levels recently – with four straight weeks of FCB Treasury selling in September. As Adler notes: “this is far beyond anything I’ve noted in the 9 years since I started tracking this data… Over the past 9 years, there has never been a time when FCBs were sellers of their Treasury and Agency debt for 4 weeks in a row.”
FCBs are using “Operation Twist” as a golden opportunity to diversify out of longer-dated US Treasuries. Does this mean that the bond vigilantes are finally coming out to play? Given that the Fed can buy any amount of Treasury debt courtesy of its printing press and its huge array of assets – the latter now well above $2 trillion – it would be foolhardy to suggest that it cannot continue to succeed in suppressing yields on US Treasuries in the short-term.
However, over a longer time period things will get a lot trickier for the Fed. More and more dollars are seeping out of the banking system and into the US economy, pushing inflation higher. This will exert an increasing upward pressure on Treasury yields. Any moves by the Fed to temper this inflation by raising the Federal Funds Rate and increasing bank reserve requirements will push yields higher still. And to top it off, with FCBs selling rather than buying Treasuries, you have all the ingredients for a serious rout in the Treasury market.
Though the timeframe for this scenario is impossible to predict with any certainty, this current FCB selling should be in the very least enough to suggest that current perceptions of Uncle Sam’s debt as a “safe haven” are seriously flawed. As the Scottish historian Niall Ferguson recently commented: “US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.”