As Dollar Plunges, Watch for US Government Bonds Sell-off

After a short break, we are resuming the reports of our special financial expert.
The sinking dollar and the soaring US stock market will lead, according to our financial expert, to a sell-off of American government bonds and, as a result, an increase in long-term interest rates.
What is the connection between the price of bonds and interest rates? And how do they affect real-estate and the stock and foreign exchange markets? A government bond is an IOU by the government to honor the debt at a specified future date. They mature after two, five, ten or 30 years. Issued to the public, the bond trades OTC (Over the Counter) on the open bond market, one of the most liquid in the trade with volumes of tens of billions of dollars a day.
The issuer (seller) in the primary market is the government; the secondary (open) market consists of a mixed bag of buyers and sellers – foreign central banks, mortgage companies, investment firms, and the public.
There is a reverse interaction between the bond’s price and the interest it carries: the higher the price, the lower the interest and vice a versa – the lower the bond price, the higher the interest.
Short-term interest rates are fixed by the central bank (the US Federal Reserve – Fed), whose next meeting on December 14 is expected to continue its policy of measured short-term interest rises. The long-term interest rate is governed by the bonds market – in other words, the market determines the price for which it is willing to lend the government money. That becomes the long term interest rate.
Every economic expert in the world has been explaining in recent months that America’s huge budget deficit and trade imbalance (America imports more than it exports) are the structural causes of the dollar’s weakness. The dollar has been sliding progressively for three years and hit new lows in recent months. On December 7, the euro was quoted at $1.3450, raising questions of the American currency’s continuing hegemony as the main reserve currency for national central banks.
In fact, the last round of dollar plunges was caused primarily by central banks diversifying their reserves by trading in some of their dollars for other currencies, mostly euros.
If investors and central banks are selling off US dollars, why don’t they also sell US assets, i.e. government bonds?
Central banks, particularly in Asia – Japan, China, Taiwan, India and Singapore – hold vast foreign exchange reserves in amounts of hundreds of billions of dollars. These reserves are generated partly by those countries’ current account surpluses (in contrast to “spendthrift America”), and partly by their dollar surplus balance, which is deliberately kept high by their central banks buying dollars in the foreign-exchange markets to build a bulwark against their own national currencies growing strong enough to impair their export trade.
Sounds complicated?
The situation of Asia’s central banks is even more so.
For example, the Japanese central bank (BOJ) purchased hundreds of billions of dollars last year to keep the yen weak, exports high and Japan’s economic recovery moving forward.
But this intervention proved ineffectual. Tuesday morning, December 7, the Japanese yen traded at around 102.50 per 1 US. dollar compared with 110-115 levels when the BOJ stepped in. Most of those dollars were routed into long-term American government bonds which are as near as possible to being defined as a risk-free asset: AAA in the risk rating
On December 7, the Wall Street Journal wrote that the US government’s triple A bond rating is being questioned by some investors because of America’s budget and trade deficits and the plummeting dollar. What is happening, therefore, is that Asian central banks, by purchasing dollars to hold down their own currencies, are helping to finance America’s huge debt by buying American indebtedness – bonds.
But miracles don`t last forever…
Alan Greenspan, chairman of the Federal Reserve, talking last month with unusual bluntness about the state of the dollar, remarked: “… considering the size of America’s trade deficit, devaluation in the dollar could occur at some point.”
Devaluation of the dollar may happen by selling off dollar assets like… American bonds.
Selling US assets=American bonds held by Asian central banks – or even a partial sell-off – could sharply depress the bond price and raise long-term interest rates.
Those banks would register a loss on their American bond holdings – which would prompt them to throw more US bonds onto the market.
Sounds like catch 22, or in market language: Pass the hot potato on to someone else….
In recent months, the manager of American PIMCO, one of the world’s biggest bond trading companies, has been recommending a reduction in holdings in the bond market.
The anomaly between currency markets (dollar down), and bond markets (fairly level) cannot last long.
The Chinese Factor.
Unlike most of Asia – and the rest of the world, China pegs its currency the yuan to the US dollar, to the annoyance of America, which is calling for a yuan revaluation. Since China is the biggest exporter to America and therefore the prime cause of America’s escalating trade deficit, the Bush government hopes for a stronger yuan to help cut that deficit.
What impact would a price drop of US government bonds have?
The effect of a sharp sell-off of US bonds on world stock-markets, real-estate and currency trading would be powerful and could even in some circumstances trigger world crises:
Stock marketsrespond negatively to rising interest rates because they make holding onto stocks less attractive to investors. In extreme cases, a sudden massive decline in the price of bonds (producing a surge in interest rates) could shock stock markets enough for a crash.
Real estateis influenced by the mortgage interest rate which derives directly from long-term interest rates in the capital markets. A rally in long-term interest rates would push mortgage rates up. With most real estate markets already at the end of a rally cycle, a further boost could cause a world real estate market collapse. (High mortgage rates would hit real estate sales and be extremely painful to holders of mortgages with floating interest rates.)
Mortgage companies are themselves active bond market players. A sharp bond sell-off would force them sell bonds, so adding fuel to the fire.
Currency marketslike all markets, dislike uncertainty. An acute increase in US long term interest rates may temporarily stimulate a rally in dollar value. But a substantial crash of American bonds will in the long run weaken the dollar. The effect on these markets will be higher volatility.
World imbalance: Since the US government bond is a popular and staple asset held by most central banks and corporate and private portfolios – large and small, a steep sell-off may spawn a world financial crisis.
What can save the bond market from falling?
1. A reduction of the US current account deficit and/or revaluation of the Chinese currency could ease the pressure on the bond market.
2. If there were to be coordinated intervention in the currency markets to soak up dollars – including by the Fed, some control might be exerted to level out the diving dollar and bonds – at least temporarily.
3. Predictions that world interest rates will not go up in the next few years – meaning inflation is not a tangible threat, despite climbing oil and commodity prices – could encourage long-term bond purchases. (This scenario is the least likely of the three)