The Global Monetary/Currency Conundrum

Here are the facts to be reconciled:

  1. M3 (or its equivalent) is growing smartly in most major nations around the world year-over-year at present.
  2. Most major central banks are tightening or on hold; few if any are loosening.
  3. The US current account deficit persists, and nations that trade with us continue to buy our bonds.
  4. The US dollar continues to sag slowly against most major currencies.

Here’s the way that I reconcile them. Many of the central banks are not very independent, and so they are under pressure not to let their currencies appreciate versus the dollar. So, they take excess dollar liquidity and buy US bonds, forestalling the problem, because bonds will pay them more dollars in the future. This gives some lift to the dollar, but not enough, because not all central banks are willing to do this, so the US dollar sags slowly.

Because of the excess liquidity, M3 rises, and in response, the foreign central bank tightens monetary policy, but then they undo a large part of it by buying US bonds as a part of their monetary base. It will take many interest rate rises to cool off these economies, or an unwillingness to buy US bonds with their US dollar liquidity.

The Business Week article that I linked to talked about how interest rates rose 1.5% in less than two months when foreigners ceased to lend to the US in early 1987. (This followed a fall in the US dollar in late 1986.) This could happen again, but it will take a large central bank that acknowledges that they have embedded losses on their US bond portfolio not reflected in current prices, and then works to limit their losses by eliminating dollar reserve.
My advice: be aware, and don’t keep all of your bonds in US currency-denominated issues.