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According to independent economist Andy Xie, escalating conflict in the Middle East could cause the USD "super bubble" to burst. (Source: Shutterstock) |
According to SCMP , as oil prices rise and the US budget deficit widens, bond yields will rise sharply. This could cause the stock and real estate bubble in the US and then elsewhere to burst.
China’s trade surplus and soaring wage inflation will only add to the pressure on the yuan’s unofficial peg to the dollar. Once that relationship is broken, the dollar will plummet.
Change the situation
The United States may be experiencing a super bubble. US assets are overvalued, debt is unsustainable and political discord makes any major policy adjustments difficult. The US budget deficit is now close to $2 trillion.
As China’s commitment to keeping the yuan within a narrow trading band against the dollar has provided a buffer against currency market concerns about a sharp dollar depreciation, the bond market is feeling the full brunt of the pressure.
However, escalating conflict in the Middle East could change the situation.
Depending on the extent of disruption to oil supplies from the Persian Gulf, Brent crude prices could rise. Inflation would rise and central banks, including the US Federal Reserve, would have to refocus on the task of cooling inflation, making it harder to bail out debt markets.
Meanwhile, the global money supply could increase by trillions of dollars. After the terrorist attacks of September 11, 2001, the United States spent an estimated $6 trillion on the conflicts that erupted in the Middle East. These expenditures mean more U.S. debt, and bond yields could rise into double digits.
Yields are still below nominal GDP growth of around 6% in the US. However, rising yields may not slow the pace of US borrowing, as there is political pressure to maintain strong spending and the US can continue to issue bonds.
If investors stop buying US bonds, the Fed may have to buy them, which would temporarily stabilize the bond market. However, concerns about rising inflation will return to investors' minds. What happens next in the US bond market could affect global financial stability for years.
Importantly, if US bond yields were to rise into the double digits, the overvalued US stock market and real estate market would collapse. The US bond market is valued at 180% of GDP. The value of US real estate is 170% of GDP. If asset prices correct, the decline could be as high as 150% of GDP.
A less stable US financial system will make it harder for China to peg the yuan to the dollar. The increasingly competitive auto sector alone could see exports rise by 20 million units in 10 years, generating a trade surplus that would make the yuan’s peg to the dollar unsustainable.
China’s labor shortage is also fueling wage inflation. If China were to float its exchange rate, it could see significant wage inflation for five years. China would be forced to unpeg the yuan to the dollar, allowing the dollar to fluctuate even more.
Potential risks
When China adopted an export-led growth model decades ago, it, like other East Asian economies, decided to implement a currency peg to the US dollar in 1994. This officially ended in 2005, but the yuan has remained pegged to the US dollar, albeit with adjustments and controlled fluctuations.
A small economy with a currency pegged to the US dollar does not change the world of dollars. But China's economy, with its large size and rapid growth, has changed the situation.
After the first bubble burst in 2008, major central banks engaged in quantitative easing, which made the bubble even bigger. China’s M2 money supply increased 5.6 times between 2007 and 2022, while the Fed’s balance sheet increased 9 times. These two figures explain the rapid increase in asset values as a percentage of GDP across many asset classes and around the world.
Rapid currency growth over a prolonged period of time has resulted in the money supply being de-linked from inflation. This is due to the entry of hundreds of millions of Chinese workers into the global economy and companies moving production to China.
The United States has embarked on a path of borrowing and spending. The quantitative easing policy implemented by former Fed Chairman Ben Bernanke paved the way. Since 2007, the US public debt has increased by about $9 trillion, to nearly $33 trillion, while GDP has increased by only half that amount.
Borrowing has easily become a habit. If the markets don’t sound the alarm, US debt could double in 10 years. Ultimately, borrowing could lead the economy into a tailspin.
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