WASHINGTON, January 11, 2017 — In the early 1990s, so-called “bond vigilantes” threatened to sell U.S. government bonds in the face of spending plans by the Clinton Administration that would have significantly increased the national debt. From late 1993 to late 1994, the rate on a ten-year Treasury note climbed from roughly 5 percent to 8 percent. The selloff helped lead to Republican control of the House of Representatives for the first time in 42 years.
During that time, Clinton’s plans were halted because borrowing costs were too high.
Today, America’s national debt is over 105 percent of Gross Domestic Product (GDP), much higher than it was in 1994. With no economic growth to speak of during these past eight years, inflation has been subdued.
Since election day, bond markets have sold off. Clearly, the “Trump-trade” is bearish for treasuries because with such a large debt overhang, Trump’s planned tax cuts and regulatory reform will spur economic growth, but also fan inflation.
After decades in hibernation, the bond markets have spoken, and it’s not pretty.
The dollar is a different story. A week after Trump was elected, the ICE U.S. dollar index hit 100.5, its highest level since 2003. On December 28, 2016, the dollar hit an impressive 103.6 on the FX Street dollar index spot chart. A month after the election, the dollar had strengthened 4.3 percent versus the euro, and the recent 25 basis point hike by the Fed, while not much, can only make the dollar more attractive, especially for yield-starved currency investors.
Despite that, the rally in the dollar is a mirage. The reason it has risen is because the other major currencies are weak. Great Britain is still reeling from Brexit, the eurozone is mired in a banking crisis, Japan is in demographic deflationary decline, and emerging markets like Brazil and India are feeling the effects of the commodities bust. Even the vaunted Swiss franc is no longer a sure thing: Deposit rates in Switzerland are negative.
There is nowhere else to go but to the dollar.
DoubleLine Capital CEO Jeff Gundlach was the only upper-echelon money manager to predict a Trump victory. While neutral on treasurys, “the dollar is going down,” he said last month.
A dollar devaluation is long overdue. The last time the dollar was officially devalued was back in 1933. By executive fiat, Franklin D. Roosevelt ordered Americans to turn in all gold coins, which were redeemable at $20.67 an ounce. Roosevelt then bought gold on the open market, driving the price up to $35 an ounce, where it eventually stabilized.
Few Americans were around back then to remember the pain of what would ultimately amount to a 70 percent devaluation. To add insult to injury, those who did not turn in their gold coins had them confiscated as contraband.
For obvious reasons, a dollar devaluation today would not involve gold. It would be electronic, with Americans learning their new net worth by logging onto their bank’s website to see how many 1’s and 0’s they have left.
In many regards, a nation’s bonds and the currency are one in the same. The recent troubles in the Europe bear this out. When a populist party in Europe gains momentum to leave the eurozone, that nation’s debt sells off. Who would buy government bonds denominated in a currency that is going away? Greek bond rates hit 12 percent in July 2015 as Greece teetered on the brink of leaving the eurozone.
Interest rates are going up one way or the other. The Fed or the markets will see to that. The dollar will be de-valued. The dollar vigilantes will see to that. The problem is, unlike a bond selloff, a dollar selloff hurts everybody (safe to say that more Americans hold dollars than government bonds).
“The biggest long-term danger to the dollar might come from the U.S. pulling back from its role as world policeman,” writes James Mackintosh in the Wall Street Journal. A cynic might recall that Saddam Hussein announced plans to sell oil in euros instead of dollars before being caught with weapons of mass destruction. Muammar Qaddafi was planning on abandoning the dollar to sell oil in dinar before being deposed; Libya is the largest oil-producer in Africa.
Conspiracy theorists might claim that Rex Tillerson leaving Exxon-Mobil to become Secretary of State proves that the dollar is in trouble and needs saving.
We know who the bond vigilantes are: Gundlach and Bill Gross, with an occasional outburst from Rick Santelli. Who are the dollar vigilantes?
The dollar vigilantes are nations that could lose faith in a currency that until the 1970s was convertible into gold. And for all intents and purposes, OPEC is a nation-state.
So who are the dollar vigilantes looking out for? Themselves mostly, but also emerging market nations that have borrowed in dollars but run into trouble when debts become more expensive to service in local currency terms. Countries like Argentina, Indonesia and Zimbabwe get suckered into IMF loans and then are forced into default when the dollar strengthens. The IMF scoops up the collateral and the people get robbed.
International Monetary Fund data show that in the last 16 years, the dollar has dropped from 71 percent of foreign reserves to 61 percent of identified reserves, an orderly liquidation, but a decline nonetheless. China, the world’s largest holder of foreign currencies, has $3 trillion in reserve. They had $4 trillion in June 2014, and drained $69 billion this past November, no doubt to defend the yuan. Emerging markets are on the hook for over $200 billion in dollar-denominated loans and bonds due this year.
When will the bottom fall out? In the early 1970s, the IMF began printing something to rival dollar hegemony, a special accounting unit that allows member nations special drawing rights (SDR) on its currency reserves. The Chinese yuan was recently added to this basket, which is why the People’s Bank of China (PBoC) has had to loosen the reigns.
The SDR makes news during liquidity crises or lapses in dollar funding, but is not in circulation anywhere as money. The dollar makes up 42 percent of the SDR on any given day, and this will probably not change in a Trump presidency.
There is an old adage on Wall Street: When a country has a problem with the IMF, they have to get in line. When America has a problem with the IMF, the IMF gets in line. A showdown between the Fed and IMF is highly unlikely. So where do we go from here?
“The U.S. dollar is our currency, but your problem,” said Treasury Secretary John Connally at a conference in Rome shortly after Richard Nixon ended the Bretton Woods system in 1971. Nervous Europeans had no choice but accept terms set forth by the administration that was protecting them from the Soviet Union. This was the same John Connally who while governor of Texas happened to be sitting in the front seat of the limousine carrying John F. Kennedy on November 22, 1963 when the president was shot and killed.
Connally was wounded as well in this attack. But he survived long enough to coordinate implementation of the petrodollar system during the Nixon Administration, which required Gulf monarchies to price oil in dollars.
This gave rise to the moniker “King Dollar.” With now former Exxon CEO Rex Tillerson likely serving as the nation’s top diplomat in the new Trump Administration, it might be another four years before the king is dethroned.