With apologies to Philip Coggan, I plagarized his FT headline from a few days ago -- he asked the same question as Brad DeLong, namely, why aren’t big bets from big macro hedge funds driving the dollar down, and thus forcing the global economy to correct its biggest imbalance? DeLong went one step further, and suggested that the hedge funds could -- collectively -- overwhelm Asian central banks with leveraged bets against the dollar, if they decided to make those bets.
Coggan (his columns are available here, but they are behind the FT’s firewall) supplies part of the answer to DeLong’s question. He argues that there is no upward limit on the amount a central bank can intervene to fight appreciation. If the People’s Bank of China wants to add $200 billion rather than $150 billion to its reserves, nothing stops it. To put it differently, to avoid appreciation, you sell your own currency and buy dollars, and you have an (almost) infinite supply of your own currency (there is that pesky sterilization problem, but let’s set that aside). To avoid depreciation, you sell dollars (or euros) and buy your own currency, and you only have so many dollars (unless you can borrow them from the Fed, the US Treasury or the IMF, or someone else with lots of dollars -- the central banks of China and Japan both now have far more "dollar denominated" financial firepower than the IMF).
That is no doubt right, but I also suspect there is more to story. The notion that the hedge funds can overwhelm markets may need to be revised after Japan’s Ministry of Finance (MOF) redefined the possible by selling some insane amount yen debt to fund an intervention war chest -- a war chest that has financed $100 billion of intervention earlier this year and is far from being empty.
The MOF, and the Chinese central bank, are effectively becoming the biggest macro hedge funds of them all. Both are making enormous leveraged bets on the dollar: selling local currency debt and using the proceeds to buy long-term dollar debt on a scale sufficient to fund a very large portion of the US current account deficit. Soros famously made $1 billion betting against the pound, and I would be shocked if Soros had not joined Warren Buffet in betting against the dollar right now. But the BOJ now has made something like a $500 billion bet on the dollar(assuming the ratio between Japan’s holdings of Treasuries and the BOJ’s holdings of Treasuries approximates the global ratio between foreign holdings and central bank holdings, which is a bit of an assumption).
Since the interest rate on the yen debt is less than the interest rate on the dollar debt the MOF is buying, there is no negative "carry" or fiscal cost associated with this bet. Of course, the real risk is that the dollar will (note correction from original post, per fatbear’s comments -- I typed the original too quickly!) depreciate/ the yen will appreciate eventually, leaving the MOF with a capital loss. But the current account deficit can be sustained (and the dollar does not need to fall) so long as the MOF (and others) intervene on a scale large enough to provide the bulk of the needed financing (and to overwhelm any outflows associated with private hedge funds betting against the dollar).
I will be off at a conference until Thursday, so I won’t be providing my usual bearish dollar commentary. But do watch the Tuesday Treasury release on monthly capital inflows into the US. Treasury Secretary John Snow is off to Europe for a meeting of the G-20 on Thursday. So also watch and see if European complaints slowing growth and a stronger Euro translate into something more than rhetorical intervention. We will know that the Bretton Woods Two system of central bank financing of the US current account deficit has reached its apogee if the European Central Bank (ECB) ever start selling Euro debt to finance the purchase of dollar debt. The ECB would then be lending the US consumer the funds needed to keep on buying European goods -- at least for a little while.