I have discussed before the importance of the yen carry trade for pumping liquidity into financial markets worldwide. But the US trade deficit may be a far greater source of easy money. The entire yen carry trade is widely estimated to be worth $200 billion. Compare this to the US trade deficit which is running at $800 billion per year.
Since many Asian countries devalued their currencies in the late 90’s, it has been much cheaper for US consumers to buy goods and services from Asia rather than from domestic suppliers. Currently, the US imports almost double of what it exports. If Asian exporters were to use their US dollar proceeds from sales and exchange it for their own currencies, their currencies would rise in value against the US dollar until trade between the countries balanced.
Instead, Asian central banks are currently intervening in foreign exchange markets by purchasing dollars from exporters at a rate that significantly undervalues the domestic currency. In effect, more domestic currency is being printed and traded for each dollar exporters earn than would have been the case had the foreign exchange market been more flexible. This causes the money supply in Asian countries to expand at a much faster pace.
Asian central banks use the dollars they have received to buy US-denominated assets, particularly debt. This has put downward pressure on US interest rates and stimulated greater lending, thereby increasing the money supply in the US as well. Much of the borrowed money is spent by US consumers to purchase more goods from Asia, resulting in a continuous cycle of money creation. Greater liquidity in Asia and the US spills over into other regions of the world via investments and trade causing liquidity to rise everywhere.
I outlined the effects of a potential unwinding of the yen carry trade in strengthening the yen, and weakening all other currencies and assets worldwide such as equities, real estate, commodities, gold, art, etc.
The unwinding of the US trade deficit will cause the US dollar to depreciate relative to Asian currencies such as the renminbi and yen. Also, declining liquidity will cause asset prices to fall. However, the US dollar gold price should do very well due of its inverse relationship to the US dollar.
What will cause an unwinding of the US trade deficit? One possibility is a slow down in US consumption arising from a collapse of the housing market. A robust housing market was integral to the economic recovery since 2002 creating employment and allowing households to cash-out their rising home equities. However, housing starts and home prices have been falling in the last year. This will eventually negatively impact the employment market and mortgage equity withdrawals causing consumption to decline, too.
Another possibility is Asian central banks, namely China, reducing their US dollar purchases in response to intense pressure from Washington. US interest rates would rise as a result, making it difficult for a debt-ridden US consumer to stay solvent.
I want to add that although I am forecasting global monetary deflation in the near-term, I believe inflation will prevail in the long-run. Central banks will be forced to combat any sort illiquidity by running the money printing presses at full steam leading to a period of stagflation. In the mean time, however, be prepared for tighter money.