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Please send this on to Eugenio Aleman at Wells Fargo

Thinking The Unthinkable: The Treasury Black Swan, And The LIBOR-UST Inversion

Posted by Tyler Durden

>   The below piece is a good analysis of a hypothetical Treasury/Dollar black swan
>   event, courtesy of Eugenio Aleman from, surprisngly, Wells Fargo. Eugenio does
>   the classic Taleb thought experiment: what happens if the unthinkable become
>    not just thinkable, but reality. Agree or disagree, now that we have gotten to
>   a point where 6 sigma events are a daily ocurrence, it might be prudent to
>   consider all the alternatives.

In previous reports, I have touched upon the concerns I have regarding the overstretching of the federal government as well as of monetary policy while the Federal Reserve tries to maintain its independence and its ability, or willingness, to dry the U.S. economy of the current excess liquidity.

Excess reserves are functionally one day Treasury securities.
It’s a non issue.

Furthermore, we heard this week the Fed Chairman’s congressional testimony on the perils of excessive fiscal deficits and the effects these deficits are having on interest rates at a time when the Federal Reserve is intervening in the economy to try to keep interest rates low.

His thinking is still on the gold standard in too many ways.

Now, what I call “thinking the unthinkable” is what if, because of all these issues, individuals across the world start dumping U.S. dollar notes, i.e., U.S. dollar bills?

The dollar would go down for a while.
Prices of imports would go up.
Exports would go up for a while

All assuming the other nations would let their currencies appreciate and let their exporters lose their hard won US market shares, which is certainly possible, though far from a sure thing.

Why? Because one of the advantages the U.S. Federal Reserve has over almost all of the rest of the world’s central banks is that there seems to be an almost infinite demand for U.S. dollars in the world, which has made the Federal Reserve’s job a lot easier than that of other central banks, even those from developed countries.

In what way? They set rates, that’s all. It’s no harder or easier for the Fed than any other central bank.

if there is a massive run against the U.S. dollar across the world then the Federal Reserve will have to sell U.S. Treasuries to exchange for those U.S. dollars being returned to the country, which means that the U.S. Federal debt and interest payments on that debt will increase further.

Not true. First, they have a zero rate policy anyway so they can just sit as excess reserves should anyone deposit them in a bank account, and earn 0. Or they can hold the cash and earn 0.

This means that we will go from paying nothing on our “currency” loans to having to pay interest on those U.S. Treasuries that will be used to sterilize the massive influx of U.S. dollar bills into the U.S. economy, putting further pressure on interest rates.

No treasuries have to sold to sterilize anything.
A little knowledge about monetary operations would go a long way towards not letting this nonsense be published in respectable forums.

If we add the nervousness from Chinese officials regarding U.S. debt issues, then we understand the reason why we had Treasury secretary Timothy Geithner in China last week “calming” Chinese officials concerned with the massive U.S. fiscal deficits. I remember similar trips from the Bush administration’s Treasury officials pleading with Chinese officials for them to continue to buy GSEs (Freddie Mac and Freddie Mae) paper just before the financial markets imploded.

Yes, they have it wrong, and it’s making the administration negotiate from a perceived position of weakness while the Chinese and others take us for fools.

But the situation today is even more delicate because of the impressive amounts of U.S. Treasuries s we will have to issue during the next several years in order to pay for all the programs we have put together to minimize the fallout from this crisis.

Issuing Treasuries does not pay for anything. Spending pays for things, and spending is not operationally constrained by revenues.

The Treasuries issued support interest rates. They don’t ‘provide’ funds.

Furthermore, if China and other countries do not keep buying U.S. Treasuries, then interest rates are going to skyrocket.

There’s some hard scientific analysis. They go to the next highest bidder. The funds to pay for the securities come from government spending/Fed lending, so by definition the funds are always there and the term structure of rates is a matter of indifference levels predicated on future fed rate decisions.

This is one of the reasons why Bernanke was so adamant against fiscal deficits in his latest congressional appearance.

And because on a gold standard deficits can be deadly and cause default. He’s still largely in that paradigm that’s long gone.

Of course, the U.S. government knows that the Chinese are in a very difficult position: if they don’t buy U.S. Treasuries, then the Chinese currency is going to appreciate against the U.S. dollar and thus Chinese exports to the U.S., and consequently, Chinese economic growth will falter.

Yes, as I indicated above.

The U.S. and China are like Siamese twins joined at the chest and sharing one heart. This is something that will probably keep Chinese demand for Treasuries elevated during the next several years. However, this is not a guarantee, especially if the Chinese recovery is temporary and they have to keep on spending resources on more fiscal stimulus rather than on buying U.S. Treasuries.

Again, this shows no understanding of monetary operations and reserve accounting. The last two are not operationally or logically connected.

Thus, my perspective for the U.S. dollar is not very good. And now comes the caveat. Having said this, what is the next best thing? Hugo Chavez’s Venezuelan peso? Putin’s Russian rubble? The Iranian rial? The Chinese renminbi? Kirchner’s Argentine peso? Lula da Silva’s Brazilian real? That is, the U.S. dollar is still second to none!