Investors in U.S. Treasuries are racking up some of the biggest losses since Paul Volcker’s day four decades ago. Yet they now have a bigger worry: how Asia responds.
The cornerstone holders of Washington’s debt are in Asia, especially Japan and China. The top 10 holders in this region are sitting on around $3.5 trillion of Uncle Sam’s IOUs just as inflation surges the most in 40 years.
That was back when then-Federal Reserve Chairman Volcker was hiking rates so aggressively that he got death threats. The resulting late 1970s-early 1980s bond rout isn’t one that most of today’s Wall Street traders remember.
In some cases, the same is true of 1994, when Volcker’s successor Alan Greenspan engineered his own tightening shock. The Greenspan Fed doubled short-term rates in just 12 months, slamming global debt markets. The turmoil helped push Mexico into crisis, Orange County, California into bankruptcy and bond dealer Kidder Peabody into extinction.
Asia recalls the dollar’s resulting rally all too well. Surging U.S. exchange rates made dollar pegs impossible to maintain, paving the way for Asia’s 1997 crisis.
The last thing today’s Fed chief Jerome Powell wants as part of his legacy is precipitating another Asia reckoning. But then, Asia could return the favor by selling huge blocks of Treasury securities to front-run a bigger yield surge. It’s not like the inflation surge is likely to moderate in short order.
It’s a Catch 22, of course. If traders got wind that the Bank of Japan or People’s Bank of China were reducing the $1.1 trillion or more each holds, markets might collapse. This gives somewhat smaller U.S. debt holders a chance at a first-mover selling opportunity.
In theory, Hong Kong could perhaps draw down its $230 billion of U.S. exposure without panicking markets. The same with India and its $218 billion and South Korea with its $130 billion. At some point, though, bond dealers in New York and London will catch on and U.S. yields will skyrocket.
This risk dramatizes the tough position in which Tokyo, Beijing and Taipei, Washington’s top-three Asian bankers, are in. Pundits often assume holding a mountain of dollars gives Asian central banks huge geopolitical leverage over U.S. policy. When President Joe Biden’s predecessor launched a trade war with China, a $1.3 trillion arsenal of Treasuries seemed Beijing’s trump card.
Well, yes and no. Is Beijing able to call the shots or is President Xi Jinping’s economy trapped? Dumping tens of billions of dollars of U.S. debt, or more, would boomerang on China as surging global yields savage export demand.
Not surprisingly, foreign holdings of U.S. debt have become the stuff of Hollywood thrillers. The plot of 2014’s “Jack Ryan: Shadow Recruit,” based on the Tom Clancy hero, had Russia trying to crash the dollar in a bid to destabilize the globe.
It’s not as far-fetched as it seems. U.S. Treasuries are, for better or worse, the linchpin asset of world trade and finance. Efforts from Beijing to Moscow to Riyadh to crypto exchanges everywhere to de-throne the dollar amounted to little.
Nor did the chaos of the Covid-19 era imperil dollar hegemony. It’s worth noting, too, that the rise in U.S. yields has been surprisingly mild considering the 6.8% surge in consumer prices in November year-on-year. Also, neither gold nor cryptocurrencies are acting as obvious inflation hedges.
Still, the specter of Powell’s team hiking rates in the months ahead has markets on edge. So do fears the Fed might fall behind the inflation curve, given that monetary policy changes can operate with a months-long lag.
Already, inflation-adjusted returns are the worst since Volcker’s day in the early 80s. Back then, Volcker’s team was fighting a so-called wage-price spiral. Powell may confront something similar. The wages and conditions that workers were willing to accept pre-pandemic in 2019 are what many are accepting in 2021.
One vital constituency the Fed needs to serve is Washington’s Asian bankers. The U.S. can’t take its reserve-currency status for granted. Few developments would undermine credibility faster than U.S. debt losing the trust of central bankers everywhere.
It’s not Russia’s military the world fears in 2021. It’s Moscow’s credit rating. Take Xi, who added his name to the pantheon of top Chinese leaders. Fine, but the default drama at China Evergrande Group means the foundations of that power are shaky.
Reserve currency status is indeed an “exorbitant privilege,” as one-time French finance minister Valery Giscard d’Estaing famously said. With it, though, comes immense responsibility. Now that inflation is perking up, the Fed needs to ensure it’s getting ahead of things. Or at least explain in detail why Asia shouldn’t call its U.S. loans.
The Powell Fed doesn’t need to pull another Volcker. But this laid-back approach to the scariest inflation numbers in decades isn’t likely to go down well 7,000 miles away.