China Sees the Elephant in the Room - Dollar Reserves at Risk

A couple of days ago, we learned that Chinese Premier Wen Jiababo is "worried" about China's holdings of U.S. government debt and wants assurances that U.S. Treasuries are safe investments. Phrased another way, the Chinese are asking the question: "why should we continue to hold U.S. dollar reserves?"

The elephant in the room, it appears, is that China has fallen prey to the fact that the U.S. has already issued more debt than it can possibly service in a low inflation (strong dollar) environment, and it continues to grow its budget deficit (and government debt supply) at a staggering rate.

The Chinese Premier asked a valid, albeit naive, question related to their U.S. debt holdings. With his back up against the wall, President Obama provided commentary eerily reminiscent of "the problem is contained" rhetoric which eminated from the Bush administration in the early days of the U.S. credit crisis.

If President Obama had the luxury of being blunt and truthful, his answer might have been a bit like this: U.S. monetary policy is abundantly clear in method and purpose - the central bank will print money in abundance until they have succeeded in counteracting the deflationary impact of massive credit destruction and inflating the value of assets held by U.S. banks. The net effect of this liquidity generation will be dollar deflation, price inflation, and a severe deterioration in the value of U.S. government debt (which is fixed in nominal terms, and repayable with deflated currency).

Where am I going with this? First, I am suggesting that the U.S. is legitimately concerned about a Japanese style economic stagnation or a 1930s style depression - this explains the green ink stains you have on your hands when you visit an ATM. Second, the Fed will error on the side of overstimulating money supply and underestimating the money multiplier - the American people and leaders have no stomach for a long and gradual solution to this crisis. And finally, an eventual normalization of the money multiplier will result in massive price inflation for goods, services and many financial assets - but massive devaluation of U.S. government debt. Yup, the Chinese, as the largest foreign holder of U.S. government debt, are screwed.

If the Chinese fail to anticipate this chain of events, the world will, within a few years, witness a transfer of wealth which is almost beyond imagination. The U.S. will not default on government debt - it will repay the debt with a severely devalued currency.

I do not, however, believe that China is unaware of these risks - and it is my opinion that they will undertake risky, yet appropriate, measures to protect the real value of their assets. I believe that China, by addressing the riskiness of their U.S. debt holdings in a public forum, is establishing the political cover needed to stem their losses by shifting parts of their vast wealth from U.S. government debt to assets which appreciate in nominal terms, such as equities - and China will be aggressive buyers of real assets, including commodities such as metals, energy and agriculture.

In order for the dollar to depreciate, other currencies will, by definition, need to appreciate. I am unwilling to make a bold prediction regarding this eventuality, except to point out that gold has a history as a monetary base - it tangible, has a finite supply and is costly to produce. The prospects of a return to some form of gold standard will grow to the extent that the supply of fiat money increases dramatically on a global scale. Gold is a very attractive asset at the present time.

Presently, I find the following investments to be particularly attractive:
Long TBT- short (inverse) play on U.S. Treasuries
Long GLD- gold bullion
Long GDX- gold producers
Long USO- crude oil
Long DBA- agricultural commodities
Long DBC- diversified commodities

With somewhat less enthusiasm, I am also attracted to the following:
Long UDN- short (inverse) U.S. dollar index
Long SLV- silver
Long UNG- natural gas
Long OIH- energy service companies
Long XLE- oil and gas producers
Long MOO- agricultural producers


Also, although equities are more attractive than treasuries, corporate debt is attractive given the fact that debt is serviced with nominal (not real) dollars, and credit spreads, on average) continue to discount a sustained deflationary environment. One way to play corporate debt versus treasuries is to be long LQD (high grade corporates) and HYG (high yield corporates) paired against a short position in treasuries (long TBT, inverse ETF) or short (TLT or IEF - long and intermediate maturity treasury ETFs).