Dying Petrodollar Could Spell Disaster for the Fed as They Try to Dissolve Their Balance Sheet

from Rogue Money:

When Janet Yellen spoke at the last FOMC meeting, she reiterated the central bank’s desire to begin drawing down their balance sheet after close to 8 years of stimulus and bond buying. However, those who pay attention more to actions than from words understand that until the Fed actually begins to start selling their bond holdings, talk from the central bank is little more than the same rhetoric they used when promising a rate hike back in October of 2013, and then never instituting one until two years later.

Yet for just this instance let us take Yellen’s words as truth this time, and expect that the Fed will begin drawing down their balance sheet slowly sometime by the end of the year. And this leads us to ask the unspoken question of…

Who will buy these bonds?

In the past there was always an easy market for Treasuries and other securities as the world constantly needed dollars and dollar based bonds to ensure they had liquidity for the energy and commodity markets. But with China and Russia having tossed down the gauntlet in 2013 for an ending of the petrodollar system, the world has slowly begun to divest themselves of their dollars, and are more and more choosing to dump rather than buy U.S. debt.

When the Federal Reserve begins reducing its holdings of U.S. Treasuries as expected later this year, some of the most consistent buyers of U.S. bonds over the last 15 years may be less than willing to fill the breach.

Before the financial crisis, the flow of “petrodollars” was one of the most powerful forces driving the U.S. bond market and the dollar, as oil exporters invested their booming trade surpluses into Treasuries.

But that flow isn’t what it once was, and may be about to dry up further. The Fed’s $1.7 trillion bond-buying stimulus has crowded out demand from oil exporters and their once huge trade surpluses have shrunk thanks to sluggish oil prices.

Far from having plenty of fresh cash to invest abroad, these countries are shoring up finances and safeguarding stability at home. – Nasdaq

Additionally, the Fed cannot really afford to wait for many of these bonds to reach maturity, as the banks and the U.S. government have not the liquidity available to buy or cover these maturing debt instruments. And in the end perhaps the best solution for the Fed would be for them to simply eliminate these bonds, and then remove the underlying credit tied to them.

But that in itself would go against the Fed’s desire for higher inflation in asset prices, because the only way a central bank knows how to increase inflation is to expand the money supply through credit expansion, and to not allow credit to be retracted as loans and debts are paid off or defaulted on.

The central bank is in a bind of their own making, and they have taken much too long to reverse their policies of ZIRP and QE. And now that they want to downsize at the same time they are raising interest rates and wanting higher inflation, this conundrum is almost impossible to solve since the outlets they had in the past to buy U.S. debt are nearly shut-off, and any real move they might do to cut back on credit expansion will drive both the economy and the markets over the cliff, causing the Fed to quickly reverse course and bring about an increase in credit the likes of which the world has never seen.

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