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The US Dollar's Triffin Dilemma Adjustment Disorder


It's critical that investors filter the noise of headline-grabbing melodrama and identify what is dominating the prevailing cyclical trend.

MINYANVILLE ORIGINAL Last week we got a slew of top tier economic data with ISM manufacturing, ISM services and non-farm payrolls (or NFP) which all came in weaker than expected. The bearish case for equities predicated on slowing economic growth surely took a hit as the S&P (^GSPC) only lost 0.55% on the week. The bears have been calling for a crash due to growth slowing and last week got exactly what they hoped for, but stocks didn't even care. Stocks seem to be focusing on other matters, and the only thing crashing appears to be the wrong playbook bubble.

This week I wanted to address a seemingly immaterial data point which I believe has material cyclical implications. Embedded in the NFP data was the breakdown between private sector jobs and government sector jobs. Private payrolls added 84K in June with May's previously 82K revised to 105K. Government payrolls shed 4K jobs after last month's drop of 28K. The net payroll number came in at 80K for June with May adding 77K. While the headline miss is disappointing, I believe the continued strength in private payrolls against the weakness in government payrolls is the real story.

Since stocks care about the private economy I wanted to know how 84K and 105K private jobs in June and May respectively stacks up against history, so I ran some averages over several periods. The 20-year average monthly private payroll gain going back to 1992 is 88K jobs. The 30-year average going back to 1982 is 103K. The 40-year average going back to 1972 is 134K, and if we take it back 66 years to 1946 encompassing the post World War II period, the average monthly payroll gain is 95. While recent private job gains may be relatively weak for a recovery, they are completely sonsistent with historical averages.

Contrast the private payroll story with the government payroll story. Since taking office in 2009, the Obama administration has seen 31 months of government job losses out of 42 through June. During the preceding four years under the Bush administration there were only 12 months of government job losses. Consider this: The June NFP report showed the private labor force to be 111,145K and the government labor force to be 21,943K. Since December 2008 when the size of the private and public work force was 111,824K and 22,555K respectively, the private labor force has 679K fewer workers (0.60%) while the government labor force at one-fifth the size has almost as many with 612K fewer (2.7%) workers.

These data points may seem immaterial for investors, but they point to an important trend.

In the fall of 2001 there were some very significant cyclical events that unfolded in the wake of the 9/11 attacks. In September 2001 one euro bought 0.92 US dollars. On November 17 China entered the World Trade Organization (WTO) and two days later WTI crude oil bottomed at $16.70. Over the next eight years the US debt outstanding would more than double, the euro would appreciate by 95% against the dollar, and crude oil would appreciate by 780%. Was it Europe? Was it China? Or was it the US?

In September 2001, the float of US Treasuries held by the public (not Intra-government Holdings i.e. entitlement liabilities) was $2.9 trillion -- an amount equal to 28% of nominal GDP. At the time foreigners owned $992 billion (34%) with China owning only $72 billion (2.5%). At last check in June 2012 the float of Treasuries held by the public was $10.5 trillion -- an amount equal to 68% of nominal GDP. Foreigners own $5.2 trillion (50%) and China owns $1.145 trillion (11%). To put another a more alarming number on this explosion in debt, the growth in Treasuries outstanding since 2001 is 260% with China's share of that debt growing by 1,500%, taking down 15% of the $7.6 trillion in total debt growth.

It wasn't a coincidence that the US government's borrowing and spending binge coincided with its soon-to-be largest trading partner entering the WTO at the same time. From the Office of the US Trade Representative:

US goods imports from China totaled $399.3 billion in 2011, a 9.4 % increase ($34.4 billion) from 2010, and up 299% since 2000. It is up 290% since 2001. US imports from China accounted for 18.1% of overall US imports in 2010.

Of course the market was not able to adjust this explosive US/China trade imbalance due to the yuan/dollar peg. What's the next best option? The EURUSD pair. As the market weakened, the value of the dollar vs the euro had a huge impact. It has, as we now know, manifested in the European debt crisis. As we discussed in the article In the Parallel Universe, Credit Risk Is Interest Rate Risk, with their newfound currency strength on the back of dollar weakness, Europeans, especially southern Europeans, were afforded way more purchasing power than their local currencies would have provided them, which lead to a debt-fueled consumption boom.

Ironically, the US consumption boom with China that saw debt explode and the currency weaken led to a stronger euro which led to a consumption boom and debt explosion in Europe. This unintended consequence of the stronger EURUSD (weaker dollar) can be attributed to the US reserve currency status and what is known as the Triffin Dilemma.

In 1960 Yale University economist Robert Triffin warned Congress about the Bretton Woods system establishing the US dollar as the world's reserve currency and the paradox that could unfold. The Triffin Dilemma explained per the IMF website:

If US deficits continued, a steady stream of dollars would continue to fuel world economic growth. However, excessive US deficits (dollar glut) would erode confidence in the value of the US dollar. Without confidence in the dollar, it would no longer be accepted as the world's reserve currency. The fixed exchange rate system could break down, leading to instability.

If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.

Yikes! In other words, the reserve currency status forces the US to supply excess dollars and thus credit to support global trade, however as that trade grows, dollars and credit grow and deficits grow, which in turn reduces the value of the currency. At some point the value of the currency calls into question the credit worthiness of the reserve currency issuer.

The rise and fall of the US shadow banking system, which was at the center of the 2008 financial crisis, was an example of Triffin Dilemma, as is the current demand of US treasuries with record supply at record low interest rates. If you want to read more, there is a fascinating IMF working paper titled "Institutional Cash Pools and the Triffin Dilemma of the US Banking System" by Zoltan Pozsar.

I realize the explosion of government debt and China's emerging role as top foreign holder has been well documented, but what hasn't been documented is how that borrowing and spending, potentially to satisfy the Triffin Dilemma, flowed through to US economic growth.

Nominal Gross Domestic Product (NGDP) is the sum of private consumption + private investment + government spending + net exports. Because private consumption dominates GDP it usually gets most of the attention, but I found an interesting dynamic between the delta of growth in private investment vs government spending and how that manifests itself in the value of the US dollar.

Between 1992 and 1998 private investment as a percent of overall NGDP rose from 13% to 17.5% while government spending fell from 20% to 17%, however both of these NGDP components took noticeable turns when the Internet bubble imploded. In the period beginning in 2000 and ending with the financial crisis recession aftermath in 2009, private investment as a percent of NGDP collapsed from 17.5% to just 10.5% at the recession lows in 2009. This represented the lowest level going back 40 years. Over the same period, as explained above via debt growth, aggregate government spending exploded but also as a percentage of NGDP. Between 2000 and 2009 public spending rose from 17% to 21% which was just shy of the 22% peak reached at the end of the Vietnam War in 1975.

Since the 2009 recession lows these trends have seen noticeable reversals as public spending has fallen from 21% of NGDP to currently 19.5% while private investment has risen from 10.5% to 13%. This tells us that since the recession bottomed in 2009, growth -- albeit more tepid than normal -- has been led by a resurgence in private investment amid a collapse in government spending. The relatively weak economic performance can be attributed to the reduction in public sector activity rather than private sector activity which continues to trend higher. This convergence of the two trends is supported by what you are seeing in the jobs data with the government shedding jobs while the private sector continues to add to payrolls.

What's interesting about this trend is that the trajectory in public spending growth is positively correlated with the value of the EURUSD. Between 2000 and 2008 the EURUSD (EURUSD=X) doubled in value (dollar weakened) from the low .80s to a peak of 1.60 just prior to the financial crisis. Subsequently the 2008 peak in the EURUSD preceded the 2009 peak in government spending, and as that has collapsed, so has the EURUSD (dollar strengthened). In other words, the dollar cycle coincides with whatever dominates growth in investment between private and public sectors.

Now consider this: The euro debt crisis is really a balance of payment crisis, meaning the debtor countries consumed more than they otherwise would have been allowed due to the strength of the euro. But if the EURUSD is positively correlated with US public spending as a ratio to NGDP, then you could argue the US government spending binge is directly responsible for the European debt binge. Therefore the recent collapse in US government spending (dollar strengthens) is part of the solution in effect devaluing the EURUSD and thus reducing European purchasing power.

It's quite possible that the 2008 financial crisis and subsequent European debt crisis was not simply about the credit/debt bubbles blowing up; it was about the Triffin Dilemma blowing up. These financial crises were just by-products of severe current account imbalances and the role of the US reserve currency status reaching critical mass.

One emerging trend that could be indicative of the unfolding Triffin Dilemma adjustment is China's recent waning appetite for US Treasuries. Since the July 2011 peak of $1.3 trillion in holdings China has been a net seller of $169 billion Treasuries coincidentally since the US credit rating was downgraded by S&P in August. So since QE II ended in June 2011, Treasury debt outstanding has continued to grow by $1.2 trilliion. Yet the two largest sources of demand for securities, especially since the financial crisis, China and the Federal Reserve, have ceased adding to their positions (Operation Twist is balance sheet neutral). Yet over the same time frame the 10YR yield has fallen from 3.00% to a record low of 1.50%.

This all posits some very alarming questions: If government spending growth is falling, why does the US Treasury continue to borrow and who owns that last $1.2 trillion of supply at the highs? Is retail financing interest expense at negative yields?

In order to effectively and optimally allocate assets in this era of information overload, it's critical that investors filter the noise of headline-grabbing melodrama and identify what is dominating the prevailing cyclical trend. Currently the consensus debate is focused on whether we are entering a cycle of debt deflation or monetary inflation. I don't intend to dispute either conclusion but rather posit that the cycle could be more specifically dominated by the tradeoff between US private investment vs public spending, and how that affects the dollar's reserve currency status. Either the US private economy demands dollars or they are exported to foreign markets.

As we stand today, the previous decade's growth trend dominated by government spending is reversing as the government is maxed out and private investment is taking back the reins. You are seeing this trend manifest itself in a stronger US dollar and a rally in US equity markets. The dollar strengthening is a product of growth being dominated by real private investment rather than nominal government spending, and it suggests the real economy is absorbing the banking system's excess liquidity.

It's possible these converging cycles roll back over, but it doesn't seem likely as the trend appears firmly in place and there is much more room to run. It also seems that the diverging discounts between the bond and equity markets point to these two converging components of GDP. The stock market is focused on rising private investment while the bond market (or Fed's monetary policy) is focused on falling government spending. As these two components continue to converge I expect the diverging discounts to also re-converge. The last time private investment dominated government spending was between 1992 and 1998. If you recall, those were pretty good years to own equities.

Twitter: @exantefactor
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