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A Global Macro Paradigm Shift


The one-way relationship between US consuming and China accumulating reserves has come to a grinding halt. This could be the next phase of the financial crisis unfolding as a new paradigm develops between the two countries.

Volatility surrounding the recalibration of the QE discount is the obvious source of market instability, but what may not be so obvious is something that looks to be brewing under the surface. In Tuesday's Economics Brief, Bloomberg economist David Powell wrote a commentary titled Euro Versus US Dollar Weakened by Slowing FX Reserves that I think highlights a very important development currently garnering scant attention. (emphasis mine)
The sum of foreign currencies held by central banks increased to $10.52 trillion in the second quarter from $10.43 trillion in the first quarter, according to data released on Friday from the International Monetary Fund. That $90.1 billion difference translates into fresh reserve accumulation of about $24.3 billion after adjusting for the changes in exchange rates during the reporting period.

The four-quarter sum of foreign-currency reserve accumulation adjusted for changes in exchange rates fell to $501.7 billion from $1.036 trillion in the previous quarter. The latest figure is the lowest since the third quarter of 2009.

This decline in the accumulation of FX reserves certainly got my attention. I ran a chart of the world FX reserves and deflated it by the DXY US Dollar Index. I overlaid the supply of US Treasury ("UST") debt outstanding and the ratio of China UST holdings per total UST debt outstanding. Powell was writing the article with the idea that the decline in reserves would be bearish for the euro. I, on the other hand, took on a different perspective.

Global FX reserve accumulation peaked in 2Q 2011. The following July, China's holdings of USTs peaked outright and also as a percentage of total UST debt outstanding. Since China entered the WTO in November 2001 prior to last year the relationship between their reserve accumulation and their accumulation of UST debt has been highly correlated and in one direction, straight up.

Between June 2002 and June 2011 China's FX reserves grew at 34% per year rising from $240 billion to $3.2 trillion. Over the same time China's accumulation of UST debt grew at 33% per year from $96 billion to $1.3 trillion. But since June 2011 both of these parabolic trajectories changed dramatically. China's accumulation of FX reserves has flat-lined at $3.2t and their ownership of UST debt has fallen from $1.3 trillion to $1.15 trillion in June 2012, a decline of $160 billion or 12% YOY. Over the same time frame UST debt outstanding increased from $9.8t to $1.1t for a rise of 13%, so China's holdings of UST debt as a ratio of total outstanding has seen a material fall from 13% at the peak in 2011 to 10% today where it was in 2008.

Why is this important?

China FX reserve accumulation is a large source of global demand for both financial assets and commodities. The US exports the reserve currency and China imports US dollar denominated assets. History has shown that when FX reserves decline on a YOY basis, as they appear to be doing now, it has the potential to manifest itself into a financial market disruption.

It can't be a coincidence that global FX reserve accumulation peaked when the Federal Reserve ceased QE in June 2011. When the Fed opted for a balance sheet neutral Operation Twist they would cease exporting excess liquidity into the global financial system and thus the USD strengthened. With an open-ended QE the big question now is whether this deflationary influence from the deleveraging US consumer can be offset by the inflationary influence of the Federal Reserve. If not we should see markets trade with a more deflationary bias.
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