The Oil Drum

Godraz,

The Current Account Deficit is basically the trade deficit. The U.S. Current Account Deficit is approaching 1 trillion per year. What this means is that the surplus countries (mostly China, Japan, and the gulf states of the Middle East) end up with one trillion U.S. dollars which they must reinvest in dollar denominated assets if they don't want their own currencies to appreciate. The last thing these countries want is for their own currencies to appreciate. So they send these dollars back to the U.S. by investing in U.S. corporate debt, government debt, agency debt (Fannie May and Freddie Mac), or corporate equities. The problem right now is that corporate equities and debt are becoming far less attractive, and agency debt and other mortgage related debt will be issued more and more sparingly as the housing bubble corrects. That leaves government debt (the budget deficit), which is only around 200 billion per year. What I was referring to in situation 2 is that there may come a time when there simply isn't enough secure, money-making, U.S. denominated assets for the surplus countries to invest their dollars in. At that point they would have no choice but to convert their dollars into their own currencies (the option of last resort from China/Japan's point of view), convert their dollars into other currencies (for example, they could convert their dollars to euros and then buy euro-denominated debt), or buy something else like gold. We aren't there yet. The federal government is only issuing 200 billion or so of new debt this year, but the surplus countries can still enter the market and buy existing debt from other parties. The expected result of this would be to drive down bond yields. Watch the ten-year bond yield, for example. It's already down to 4.74% from above 5% a couple of weeks ago. That drop from 5% to 4.74% might not have anything to do with the Current Account situation described above, it is more likely just the result of people expecting economic conditions to worsen going forward (which also tends to cause yields to fall). But if at some point you see that yield really starting to tank, then the economy starting to pick up (since mortgage rates are tied to the yield on the ten-year bond), inflation picking up, asset prices spiking back up again, the fed raising interest rates to try to deal with inflation, and then the ten-year bond yield continuing to fall even in the face of Fed tightening, you will know it is because the surplus countries are buying up huge quantities of existing debt. The bottom line is that if the Current Account Deficit is 1 trillion, the surplus countries must find 1 trillion worth of U.S. dollar denominated debt to purchase. If they can't, they will be forced to begin purchasing something else, and this will lead to a dollar collapse.