The Fed Pays a King’s Ransom to China

America’s economy is in shambles.  Fiscal policy is totally gridlocked between Democrats who want to see some long term tax increases, and Republicans who only want spending cuts.  Worse yet, the Republicans view economic failure in America as a good thing as they believe it will enhance their chances of recapturing the White House. Because compromise on the budget seems to be off the table right now, that leaves only the Federal Reserve policy to stimulate the economy.  So, judging from what’s been reported in the financial press and on TV lately, the Fed’s policy is ringing loud and clear:  Keep interest rates at record lows, and devalue the currency. 

Keeping long term interest rates low is desired because the Obama Administration is praying that loan and mortgage refinancing will put more money into the pockets of corporations and individuals, giving them money to spend.  A lower dollar is also desired to help boost exports. Selling more abroad is, for now, the only way to create more jobs.  In other words, fiscal policy is frozen like a deer in the headlights and easy money is the only policy our government’s got.  There is just one big problem with a policy of low interest rates and a weak currency. 

Foreign central banks, led by China, currently hold $3.5 trillion dollars invested in US treasuries.  China created goods that they sold to America for dollars but now we want to pay them nothing in interest and devalue their savings held in dollars.  Indeed, it must be galling to the Chinese that we are treating them this way.  (It’s ironic but we’re treating our retired savers in our own country this same way).   Needless to say, China understands what’s going on and it has them more than a little pissed off.  At some point, they could cut their losses and swap their horrible investment in paper dollars for tangible assets such as gold and other resources they need to employ, feed, clothe, and house their 1.3 billion citizens.  

Countries holding US treasuries face a two pronged dilemma:   First, if they dump longer term treasury securities, they would suffer massive price declines because selling long term notes and bonds pushes their prices down. Second, foreign countries would suffer currency depreciation losses because selling dollars pushes the dollar down.  If China and other central banks all sold their longer dated treasury notes and bonds, US treasuries would decline in price, causing long term interest rates in America to soar.   At this time in American history when our economy is so fragile and weak, rising long term interest rates could spell disaster for our economy.  This is the Obama Administration’s greatest fear especially as we approach an election year, so they had to come up with a plan so foreigners dumping their longer term US treasuries wouldn’t hurt us.  Since monetary policy is all we’ve got, the Fed was called in to fix the problem.

So what else could the Fed possibly do to keep our economy moving in the right direction?  Why not go to the Chinese and promise to pay them a big fat premium on their current long term treasuries (that were purchased at much higher interest rates) and let them swap them into short term treasury bills and notes. Indeed, looking at the prices of US Treasury notes and bonds, most are trading at premiums of 10 to 15 percent for recent issues, and 50 percent or more for those issued just a few years ago.  By allowing other countries to get out of longer term treasuries at a time of record low interest rates, it will give them an extraordinarily large gift and potentially enormous profits that can be used in several ways:  China would likely use the profits to offset currency losses when the Fed goes back to printing money in QE3 to fund our deficit; and, in Europe, the profits could be used to help recapitalize their banks which are loaded up with Greek, Irish, Italian, and Spanish debt.

When foreign countries have fewer treasury notes and bonds left in their arsenal to sell, when they do get around to selling their dollar holdings it’ll push the dollar down without pushing interest rates up.  (Note: Short term treasuries will not go down in price if sold. Indeed, they can only go down if the Fed raises rates, and even then they quickly adjust back to a par price of 100.) At that point, America can dare China to sell the dollar, because pushing the dollar down is our policy.

So basically now you know what the Fed’s recent “Operation Twist” is all about (a more appropriate name might be “Operation Payoff”).  We are paying a King’s Ransom to pave the way to devalue the dollar in the next QE3 and beyond.  Just remember the downside of a falling dollar will be higher import prices and higher inflation.

If you would like to participate in Operation Payoff, do what the Central Banks will be doing: Sell your long term treasuries to the Fed and then brace for the next round of dollar devaluation and inflation which will soon be on the way.