US Debt Rises but China and Asia Are Buying Gold: Who Will Still Want to Finance the Dollar Standard?

While all investors are focused on the stock market’s performance to understand whether a crisis is coming, the trends in Gold and the Dollar are telling us that the crisis is already underway and is probably irreversible.

by Maurizio Novelli, Lemanik portfolio manager

The most important event of the last two months is certainly the steady, vertical decline in Japanese government bonds (JGBs), an event that has required intervention by the FED and the BOJ to stop the dangerous downward spiral now in progress. Japan is currently still the main financier of US debt together with Europe, but the recent dynamics unfolding in the currency markets are triggering problems in the stability of the currency system based on the Dollar Standard.

To fully understand the importance of what is happening, we need to start with the mechanism that sustains the Dollar Standard and how it works. In practice, everything is based on the fact that China, EM, Japan and Europe invest their excess domestic savings and trade surpluses in American debt instruments (Treasuries, Corporate Bonds, and debt securitizations). By doing so, they finance the expansion of US debt, which is a liability for the United States but becomes a reserve asset for those who finance it, given that the Dollar is the world reserve currency in a system based on the Dollar Standard.

When the countries that finance American debt buy Gold, they automatically trigger a mechanism that interrupts such financing. In fact, buying Gold amounts to a drain of liquidity from the international financial system, since Gold, once stored in a vault, finances no country in the system except those that produce it (Russia, Canada, South Africa). It is therefore obvious that global foreign-exchange reserves accumulating in physical Gold are not deployed in instruments financing the system’s debt, whether that is American debt or the debt of any other country.

This phenomenon creates a net drain of liquidity from the system precisely when the world’s main debtor, the United States, is expanding debt to avoid a recession and a financial crisis. So, calculating global reserves by including Gold in no way shows what is really happening, namely that the global foreign-exchange reserves supporting the Dollar Standard are shrinking sharply. Since China and EM have been the main buyers of Gold over the last two years, we can consider that two of the main financiers of US debt are effectively exiting the Dollar Standard. By buying Gold in significant amounts, China and EM are withdrawing liquidity flows from the US system and the global financial system.

At present, Japan and Europe are the only two remaining financiers of the Dollar Standard and of the expansion of US debt. Europe has not reduced its positions in Dollar assets, but it has bought Gold, so it has partly contributed to reducing liquidity flows in the international financial system. Japan, however, has not bought Gold; it has kept the Yen weak so as not to undermine carry trades, and therefore has not reduced financing flows to the Dollar Standard, that is, to the United States. We can therefore consider that Japan currently remains the main financier of the international financial system. Since China and EM (more than 50% of global GDP) are now less inclined to finance this system, it is extremely important that the two remaining financiers, Europe and Japan, be in a strong macroeconomic position in order to continue supporting the Debt Driven Economy USA. They must grow, build surpluses and reinvest abroad.

And this is where the problems begin. Europe currently has USD 8 trillion (foreign-exchange reserves and private savings) invested in American financial assets, but urgently needs to implement expansionary fiscal policies to restructure the economy, manage the green transition and restart investment in technology and infrastructure. It therefore needs to use its excess savings at home rather than abroad. If the Russia-Ukraine war were to end, domestic capital needs for reconstruction would become explosive and Euro interest rates could rise sharply. To best finance the EU system and any post-war reconstruction, large amounts of capital will be needed, currently invested in the American financial system. It therefore seems clear that the next pillar of support for the Dollar Standard set to fall is Europe. The Euro thus faces a historic choice: remain in stagnation and therefore enter a structural crisis, or move toward greater integration and consequently provide less capital to the United States to finance its own growth.

It should be stressed that the current geoeconomic context would not allow Germany to oppose the issuance of common debt and accept greater financial integration. The crisis in Japanese JGBs now appears much clearer if read through these dynamics. Japan has launched reflationary policies to escape stagnation and needs expansionary fiscal policies to support these strategies (as it happens, just like Europe). Rising inflation, perceived by Japanese households as clearly above the “political” 2.5% level that they would like us to believe, has triggered a political crisis, a currency crisis and a crisis in JGBs. At this point, one would like a strong Yen to contain imported inflation, keep rates low to control the cost of rising debt, continue to support carry trades (Dollar Standard) and stop the fall in government bonds.

Good Luck! It is highly likely that inflation data will be suitably “cooked,” as in the United States, in an attempt to deceive the markets; however, as in the United States, the problem of “affordability” will keep growing and therefore public support for consumers can never be stopped. The United States and Japan will therefore be bound in a “death embrace” that will require endless reflationary policies, with debt out of control, controlled rates but inevitable currency crises (in the Dollar) and in debt securities (JGB). Europe will begin to step back from the system, as will China and EM for internal reasons; after all, the current geopolitical posture of the United States is asking exactly this of Europe: greater autonomy.

Japan and the United States will therefore have to put in place an (unofficial) fixed-exchange-rate system to keep the Dollar Standard alive; the Dollar and the Yen will be constantly managed by the FED and the BOJ, as will the yields on their respective government bonds. The consequences of this shift within global liquidity circulation, the reduced participation of China and EM, and later Europe, are already evident: the FED has had to return to QE to offset the contraction of liquidity in the system, the Dollar has entered a further phase of weakness, the Fed and the BOJ have intervened in the markets, and Gold has hit new all-time highs. At this point the problem will intensify when European savers grow tired of losing money on their long Dollar positions invested in American assets.

The largest long position ever, held by foreign investors in American financial assets, requires a constant expansion of global reserves under the Dollar Standard and a strong Dollar to be sustained. When EU outflows begin, liquidity in the US system will undergo another sharp contraction, the FED will have to print even more, the Dollar will weaken further and the cross with the Yen, along with the international financial architecture, will come under pressure. At that point we will see whether Japan is willing to step in for the European investors and buy more American assets, bearing in mind, however, that to do so it will have to redirect part of its liquidity, needed to finance reflationary policies, toward the Dollar and US debt. At that point the fixed Yen-Dollar exchange rates will not be able to hold, and the repercussions on Japanese bonds will once again put upward pressure on JGB yields.

In short, certain mechanisms cannot be stopped by intervening in the markets without changing the policies that caused the interventions in the first place. While all investors are focused on stock market performance to understand whether a crisis is coming, the trends in Gold and the Dollar clearly tell the story of a crisis already underway and practically irreversible. If more than half of global GDP (EM and China) steps away from the system by buying Gold, it means that a historic shift is already under way and that something is being prepared that you obviously cannot see in equity markets, since most equity traders today live off “Alice in Wonderland” narratives.

The indicators that the system is heading for a crash are rather obvious, but it certainly will not be the stock market that tells us when to reduce portfolio risk, nor the spreads on corporate bonds, since these two asset classes are currently being blatantly manipulated by policymakers. Moreover, these asset classes are also “contaminated” by the passive approach, where all investors are necessarily forced to be trend followers in order to stay glued to benchmark performance and avoid underperforming their competitors. When this mechanism replaces active management, risk management in the financial system breaks down and everyone ends up replicating exactly, and only, market risk.