Brad DeLong's Semi-Daily Journal: A Weblog

Why would an Asian central bank dump USD, no matter what their point of view, when that would undermine the value of a major hard currency holdings? They have an exposure that's too big to hedge, so the only thing to do is keep propping up USD by continuing to buy USD debt.

I'm not saying it's ultimately a great plan, but it seems like they have continuous short-term reasons that force them to keep coming back to the spigot.

"why haven't all the private-sector overseas holders of the enormous stock of dollar-denominated assets dumped them yet?"

Surely, like in any bubble, no-one wants to be first?

Brad, there is a good reason why many holders might not dump USD-denominated assets: "the market can remain irrational longer than you can remain solvent". Think of somebody who dumped/shorted dot-com stocks in 1999. Even though it was clear that there was a massive bubble, the stock prices kept going up, and those who exited early looked like fools. Only for a year or so, but long enough.

I'm beginning to think that the lack of dumping is due to benchmarking in the mutual funds sector. A lot of the Fixed Income Funds have benchmarks and the measure of success is based on relative performance. And as a risk management measure, there's a minimum amount of US Treasury bonds they usually have to hold -- and they've already been holding that amount since the beginning of the year. The great dumping has already occurred -- they're simply not allowed to jettison all the US bonds from their portfolios.

Anonymous: Ah, I think Larry Summers called your argument 'the balance of financial terror'. The question is whether they want to keep buying at an exponential rate to prop the dollar up.

It helps to think of this as a repeated Prisoners' dilemma game. And like all finite-period prisoner's dilemma game, the moment both players realise that the game is going to end at some period in the future, the game is over now because they have no reason to continue playing. I think we're getting close to that point. (A crude characterisation though because the two players have objectives other than not losing that much money in the Treasury market.)

What's worse is that it's actually better for the US and world economy for the game to end now because the imbalances would get bigger in the meantime and the adjustment process would be much harsher then.

Good point Barry. I think it is reasonable to assume that if and when foreign investors decide enough is enough, we will see a double bubble bursting. (And I'm not talking chewing gum here). If the gov't is forced to raise interest rates here at home to stem the tide, watch what happens to real estate values here at home in already overvalued segmented markets.

two thoughts:

a) don't underestimate the importance of the foreign central banks in the broader market. The treasury's TIC data shows foreign central banks holding $1120 of the $1850 billion in treasuries held abroad, and the Higgins and Klitgaard paper Prof. Delong has cited indicates that the reported holdings of Treasuries are well under foreign central bank's total holdings of dollar reserves, so in practice foreign central banks probably hold more than $1120 billion in Treasuries. Central Banks are less important in other markets, but I think they now hold over $2 trillion in dollar denominated assets -- not chump change.

2) And to reinforce Barry's point, given the spread compression in the dollar denominated high yield and emerging market bond markets combined with a treasury market that demands a yield of less than 4.5% on 10 year money, there has been a big rally over the past few years in the price of high yielding dollar denominated fixed income assets ... I have not tried to do the math, but the rally probably was not enough to offset the euro/ dollar, it still made holding these assets a lot more bearable for many different sets of investors.

"In the last two months the bond market has revised upward its inflation expectations for the coming five years considerably..."

Obviously the bond market wasn't listening to Robert J. Samuelson when he said in the WaPo yesterday that "The Age of Inflation is finished."

http://www.washingtonpost.com/wp-dyn/articles/A26864-2004Dec1.html

Perhaps many are hedged, and the others (read: central banks) need to remain unhedged lest their hedging undo the dollar-supporting effects of their transactions.

"who in their right mind is buying?"

Well, does the Fed or someone publish these numbers to the web?

I don't pretend to know why all the private-sector overseas holders of the enormous stock of dollar-denominated assets haven't dumped them yet.

But I can, I think, help you think about the question...

First: Who ARE "all" (or the most 'significant' of) those 'private sector' persons/institutions holding all those dolar-denominated assets? Surely there aren't REALLY all that many of them.

You know what they say: You can't tell the 'players' without a 'program'...

Second: WHO tells THEM what to think about (and/or DO with) their assets? What are THOSE people thinking (and/or SAYING they think)?

Why?

"But the answer to question (2) remains a mystery to me--and to everyone else."

It'd be interesting to look at bilateral BoPs to get an idea about what country's private investors are still buying US assets. Are these European investors counting on a succesful intervention? Are these pseudo-private Chinese investment banks? Just brain-storming, obviously.

Aren't the Asian countries dependent on us continuing to buy their exports? If these were private investors, then it would certainly make sense for them to dump their dollars. But my understanding is that these are national banks, and I'm guessing their governments are leaning on them not to dump. Dumping will provoke a severe recession, if not depression, in the US, which would then spread around the world, and these countries would lose their markets for their exports. I'm convinced that if we weren't the biggest consumers in the world this would have happened already--probably right after the election.

Aren't the Asian countries dependent on us continuing to buy their exports? If these were private investors, then it would certainly make sense for them to dump their dollars. But my understanding is that these are national banks, and I'm guessing their governments are leaning on them not to dump. Dumping will provoke a severe recession, if not depression, in the US, which would then spread around the world, and these countries would lose their markets for their exports. I'm convinced that if we weren't the biggest consumers in the world this would have happened already--probably right after the election.

The fourth largest holders of Treasury debt are hedge funds, with $100B (compared to $180B held by China). These funds are probably engaged in the "carry trade" in which they borrow at the short rate using huge amounts of leverage, and buy bonds with longer maturities to collect the difference in yields. Of course, when rates go up they are going to blow up (as the value of their bonds goes down), but in the current environment there are not very many other sources of yield.

See here for largest holders of Treasury debt:
http://infoproc.blogspot.com/#110153422363556066

On the other hand, inflows into US equities by foreign investors have begun to reverse, which is certainly cause for concern.

You can see that this could all lead to a very nonlinear and nasty endpoint, with everyone dumping US dollar denominated securities at the same time.

So, what would the plan of these central banks be when the imbalances grow ever greater?

"Given all the reasons for the dollar to decline, why haven't all the private-sector overseas holders of the enormous stock of dollar-denominated assets dumped them yet?"

Maybe there's not a single reason.

Japanese private investors may think the Bank of Japan will not let the dollar sink lower than 100; this would give a floor where they would hope not to lose more than 2-3% on the exchange rate, while they could imagine an upside of 130 or so.

South American private investors may still have more faith in the dollar than their own currencies.

European private investors may think that, even if in the short-term they will lose money, in the long-term the euro is more overvalued than under- vs. the dollar. And in the short-term, they're probably thinking the ECB will intervene "pretty soon."

I'm not saying any of these theories are correct, just that they're out there.

Will foreign investors jump into U.S. stocks if private social security accounts look imminent? And, will they bid up dollars to buy those stocks? And so on.

This NYT article
(http://nytimes.com/2004/12/04/business/worldbusiness/04banker.html?hp&ex=1102222800&en=32d476d15315df6e&ei=5094&partner=homepage ) profiles central bankers in Japan and China. A couple of important points: the majority of Japanese dollar holdings are in US Treasury debt: $720B out of $812B, whereas the PBOC only holds $180B out its $600B in dollar reserves in Treasurys, with the rest in agency debt (Fannie, Freddie), mortgage backed securities, etc. China views its dollar reserves as a component of national wealth, so has been managing it for return, not just as a strategic instrument of trade, which explains the greater diversification.

"...In Beijing these days, one of the fastest-growing fortunes the world has ever seen is managed by fewer than two dozen traders, chosen for showing mathematical brilliance at China's top universities.

...In contrast to Japan, China's money managers, while selling little of their existing Treasury holding, have not been buying much more. China's foreign currency reserves rose by $111.3 billion in the first three quarters of the year, according to official Chinese data. But its Treasury holdings, American filings show, climbed by only $16.4 billion.

Instead, officials at the State Administration of Foreign Exchange in Beijing have been seeking higher yields by plowing billions of dollars a month into bonds backed by mortgages on houses across the United States, according to bankers who help Beijing manage the money. By helping keep mortgage rates from rising, China has come to play an enormous and little-noticed role in sustaining the American housing boom."

http://infoproc.blogspot.com/#110214254328929755

A possibly large fraction of the "private" holders may be Japanese financial entities desperate for yield -- life insurance companies, for example. While they face possible doom at some time in the future if the dollars ever really crashes, they may face certain doom very soon if they do not have cash flow, which they won't get from JGB's. Also, they may face retaliation from the MOF if they bolt for the exit.

Here is the NYT take on who is buying U.S. dollar-demominated debt and why they are holding it:

http://nytimes.com/2004/12/04/business/worldbusiness/04banker.html?hp&ex=1102222800&en=32d476d15315df6e&ei=5094&partner=homepage

Brad,

Large overseas investors, specifically Asian investors, are supporting the dollar for as long as possible because a US currency collapse would wreck their export market.

.002
-McN

I can see both a rational-market case (the devaluation to date is a best estimate of future value, so why sell now?) and an irrational-market case (per R Fritz above, the market can punish me more than I can punish it) ... though I'm not comfortable with either.

Or is somebody big laying back, fixing to bust the dollar for strategic effect?

So I'm dumb " why haven't all the private-sector overseas holders of the enormous stock of dollar-denominated assets dumped them yet?" but so are you. Why hasn't Brad DeLong dumped his stock of dollar denominated assets ?

In my defence, my stock is small and I consider it a hedge against US college tuition. You are hedging against a lot of sticky prices in dollars but I mean a sure thing is a sure thing.

My honest explanation of why I still own dollar denominated assets is that I am throwing good Euros after bad. I hate to sell for 75 Euro cents something that I could have sold for Euro 1.20.

I for one am about to face facts. Watch out.

The 10-year forward price of the US dollar is at historic lows right now compared to European and Japanese debt. These prices have only been witnessed during dollar-bear market hysterias of 1995 and 1987, and investors who sold at these levels lost money.