Dollar Is Dirt, Treasuries Are Toast, AAA Is Gone

(Bloomberg) -- The odds on the dollar, Treasury bonds and the U.S. government’s AAA grade all heading for the dumpster are shortening.

While currency forecasting is a mug’s game and bond yields can’t quite decide whether to dive toward deflation or surge in anticipation of inflation, every time I think about that credit rating, I hear what Agent Smith in the “Matrix” movies called “the sound of inevitability.”

Currency markets have been in a weird state of what looks almost like equilibrium for the past couple of months. What’s really going on is something akin to an evenly matched tug of war that fails to move the ribbon tied around the center of the rope, giving the impression of harmony while powerful forces do silent battle until someone slips.

“All currencies are being debased dramatically by their central banks at extraordinary speeds and so in relative terms it appears there is no currency problem,” Lee Quaintance and Paul Brodsky of QB Asset Management said in a research note earlier this month. “In reality, however, paper money is highly vulnerable to a public catalyst that serves to acknowledge it is all merely vapor money.”

Flesh Wounds

Why pick on the dollar, though? Well, not necessarily because the U.S. economy is in worse shape than those of the euro area, the U.K. or Japan. The biggest problem is that external investors -- particularly China -- have more skin in the dollar game than in euros, yen or pounds, which makes the U.S. currency the most likely candidate to meet the cleaver in a crisis of confidence about post-crunch government finances.

China owns about $744 billion of U.S. Treasury bonds in its $2 trillion of foreign-exchange reserves.

Chinese exports, though, are dropping as the global economy weakens, with overseas shipments declining 23 percent in April from a year earlier, leaving a nation that has already expressed concern about its U.S. investments with less to spend in future.

‘Heavy Hand of Government’

Those kinds of concerns are starting to surface in a steepening of the U.S. yield curve, driven by an increase in 10- and 30-year U.S. Treasury yields. The 10-year note currently yields 3.23 percent, about 235 basis points more than the two- year security, which marks a near doubling of the spread since the end of last year.

“When the government parks its tanks on capitalism’s lawns, that spells trouble for those who invest, add value and create jobs,” says Tim Price, director of investments at PFP Wealth Management in London. “Trillion-dollar bailouts do not only leave massive public-sector deficits in their wake, they also leave the presence of the heavy hand of government all over industry and markets, so the outlook for government bonds is less promising than the economic textbooks on deflation would have us believe.”

Earlier this month, the U.S. reported the first budget deficit for April in 26 years, with spending exceeding revenue by $20.9 billion, even though that’s the month when taxpayers have to stump up to the Internal Revenue Service and the government’s coffers should be overflowing. So far this fiscal year, the U.S. shortfall is $802.3 billion, more than five times the $153.5 billion gap in the year-earlier period.

By - Mark Gilbert
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