[threadbear]

redundant

[threadbear]

$this->bbcode_second_pass_quote('Twilight', 'F')oreign exchange controls would be nuts. It's bad enough that investors may be taking losses on dollar-denominated assets, but telling them they can't take their money out of America would be a recipe for a run on every market. Under what possible circumstances would the US stand to benefit from that? Especially as oil exporting countries are heavily invested in the US. The phrase is starting to get worn, but no-one could be that stupid.

[Twilight]

I would certainly agree with that, threadbear. I wouldn't blame an American paid in USD with money to save or invest, for running an account in a Canadian or European bank right now. I wonder too, how that would affect some expatriate workers who would have additional incentives to do the same. Whatever the popular rhetoric these days, I expect ordinary people to take a hit before the sovereign wealth funds do.

[MrBill]

The problem is that there is no mechanism for the USA to default on foreign debt versus domestic debt because both are issued in USD and are fungible.

This is unlike the default in Argentina where Argentina forced foreign investors to accept a haircut of 65% on their USD bonds, while they froze USD loans, but still acknowleged peso deposits.

Or like Russia that issued both USD denominated bonds, but also ruble denominated treasury bills as well, so they could selectively default on one class of bonds, but honor the others.

Were the US to default on their USD denominated bonds they would have no way to, say, punish foreign investors like China without taking down domestic banks, mutual funds and individual investors at home as well.

As soon as they tried to ring fence domestically owned bonds they would create a black market for foreign owned bonds. The mechanics are quite easy (I have done this before). You wait until almost maturity when the foreigner is facing, say, a 65% haircut on their redemptions, but you are allowed to redeem at face value. You then offer them 'something' more than 35% for their bonds. If they do not like it they can only get redemption at whatever the government is offering.

How ugly can it get? During the Russian crisis I was able to buy Ukraine treasury bills at up to 3000% p.a. with three months to maturity from investors desparate to get out at any cost. I was paid out at par as a domestic investor (bank) in Ukraine. That was a real nail bighter, but I figured out that the worst that might happen was that my short-term tbills would be converted into long term debt and I would get 60% of face value over time. A high risk, but worth it as my own assets were trapped in hryvnia, so there were only limited means to stay ahead of the default and devaluation of the currency as well. Gold was another.

On the other hand if the US defaults on all USD denominated debt then it will collapse all those 401K with bonds in them; the stock market; mutual funds; US banks holding bonds; etc. Not only would it cause a dollar collapse and severe recession/depression, but the US government would then be forced to issue debt only in foreign currency as its own USD bonds would of course be worthless. Never say never, but as it controls the printing presses, it is far more likely to inflate its way out of its existing obligations.

Ultimately capital controls do not work as the Chinese are not likely to accept devalued US dollars for their exports if they know they will trapped in a burning house. And for US citizens the result is again the black market. Like in S. Africa those who are desparate to get their funds out of country can circumvent the capital controls by buying assets in dollars and then moving those assets abroad to be sold in euros or another currency.

In the run-up to the euro there was a boom in art and antiques as well as Spanish real-estate for example as a lot of gray market money tried to avoid having to exchange lira, franc and deutschmarks for euros officially. Capital controls usually enrich one subset of investors at the expense of others. They do not help the country to deal with the underlying structural problems, which in the case of the USA is borrowing far beyond its means to repay without real economic hardship. It is a self-inflicted wound.

[evilgenius]

I think there is a real possibility that the 10 year is going to go below 4%. The high end seems to be where the action is of late (Fri. 11/9). That means that the smart money has probably either seen a bad trend and acted or that they are trying to preserve the low end for later date movement.

What these lower yields mean in the long term is that new interest in US issues are not being offered much of an incentive to invest in dollars. The new issues can only be sold at a huge discount. The players with the money to pick the stuff up could be looking at a gain but the trend that brings the gain will not be good for financing the US debt obligations going forward. Either TPTB think they are going to be able to turn things around when demand destruction hits or they are crazy with arrogance.

[MrBill]

$this->bbcode_second_pass_quote('evilgenius', 'I') think there is a real possibility that the 10 year is going to go below 4%.

What these lower yields mean in the long term is that new interest in US issues are not being offered much of an incentive to invest in dollars. The new issues can only be sold at a huge discount.

[evilgenius]

$this->bbcode_second_pass_quote('MrBill', '')$this->bbcode_second_pass_quote('evilgenius', 'I') think there is a real possibility that the 10 year is going to go below 4%.

What these lower yields mean in the long term is that new interest in US issues are not being offered much of an incentive to invest in dollars. The new issues can only be sold at a huge discount.

[MrBill]

EG you bring up an important point about implied exchange rate parity versus interest rate differentials.

First of all we should consider these inescapable facts.

The USD, EUR and GBP are all freely convertible against one another.

As they can be freely bought or sold agianst one another their current spot price should reflect all known information both public and private about their fair value (i.e. efficient market theory).

The USD, EUR and GBP therefore are going to trade against one another based on

a) perceived economic fundamentals, and
b) expected interest rate differentials.

Again the theory being that the interest rate differential compensates the buyer of a currency (CCY A) for the additional risk that it might depreciate against another (CCY B).

If this were not the case then there would be a risk free arbitrage through the cross currency swap market.

And as an aside one of the reasons that the yen carry trade has been such an anomally.

So the value of the USD, EUR and GBP as stores of wealth, or investment currencies (looking on at 10-year treasuries that is), is dependent on

a) the yield between bunds (for example), tbills and gilts, and
b) the actual foreign rate between currencies.

We see today that they are

10y UST = 4.244%
10y bunds = 4.091%
10y gilts = 4.743%

Based only on yields one would invest in first gilts, then UST and only finally in bunds. Alternatively you might focus on real yields net of inflation against growth expectations.

But what about the FX risk? There is only 6/10ths of a percentage of yield separating the various investment alternatives to compensate an investor for that risk. And 10-year risk I might add. The longer the duration the bigger the impact on bond prices of small rate changes in the short-term.

As we know the EUR has appreciated from approx. $1.2900 to $1.4585 or about 13%. However, that was partially due to the perception that the Fed was done tightening while the ECB still had about another 0.50-percent to go. Now that perception is changing, so forward looking support the EUR vis a vis the USD, due to interest rate differentials alone, is eroding. Should the ECB actually turn to an easing path then that perception would be further eroded.

The GBP has appreciated from approx. $1.9230 to $2.0665 or about 7.5%. Now the expectation is that the UK as well has a weak housing sector, credit problems, and that the BOE will itself start to ease rates. That will also undermine interest rate differentials and lower rates will put downward pressure on the 10 y gilt yields as well reducing the yield spread of UST.

Both events are likely to be USD friendly against the EUR and GBP unless you feel strongly - and I guess many of you do - that the US is a victim of its own fiscal deficits and monetary policy, and therefore the appetite for US assets from foreign investors in wanting rapidly.

You may be right, of course. But you cannot make that case based on implied exchange rate parity versus interest rate differentials. They tell a different story. Just something to think about. Cheers.

[evilgenius]

Yes, Mr. Bill, all things being equal you would have this argument, but I think there is a real chance that both the BOE and the ECB are going to try and fight peak oil induced inflation with monetary policy. The US is between a rock and a hard place on that one. There could be an even bigger rate differential, or perceived one possibly, what with the Fed either standing still or being forced to lower and Europe raising or holding. Even that wouldn't see my point here, however, because with oil in dollars that makes the effect in Europe of higher energy less than would be with parity. What makes my point scary is when the Fed is trapped lowering because of severe recession at the same time that there appears a reason for lack of confidence in the US as global goliath (total loss in Iraq?), hence undermining the threats behind dollar domination. Under that scenario there is then no reason for the world not to dump the dollar and flock to the higher yielding currencies. I see it as mishandling to allow the state of US monetary policy to veer so far off the reservation when it comes to Central Bank coordination. It is the next thing to whoring.