Despite tepid economic growth, weak leading indicators and nearly non-existent inflation expectations, the Federal Reserve has been talking up the idea of another rate hike over the summer, maybe as soon as June. While many people waste their time trying to argue with a Fed that doesn't listen to them in any way, in fact, doesn't even know they exist, maybe a smarter use of time would be to consider exactly what is motivating the Fed to talk about raising rates.
I think there is a very simple explanation to why the Fed is looking to raise interest rates. In a day where the U.S. is importing less Middle Eastern oil, the incentive for Saudi Arabia and its allies to continue to pump petrodollars into the U.S. is diminished. If those nations should start selling U.S. Treasuries, then there would be a significant problem for the U.S. as it tries to finance around one-third of her debt the next couple years.
The attached chart vastly understates actual U.S. debt holdings by Saudi Arabia, as implied by their recent threat to unload up to $750 of U.S. holdings if a law passes that would enable Americans to sue Saudi Arabia for the terrorist acts of September 11th, 2001.
I talked about the complicated U.S. and Saudi relationship just a few weeks ago in an article titled "The Curious Case of Revealing Saudi Arabia's Treasury Holdings" in which I suggested that there is more than a stealth struggle going on between the U.S. and Saudi Arabia which can be directly tied to 9-11.
If Saudi Arabia unloaded even a few hundred billion of U.S. Treasuries in the next year, that would add significantly to inflationary pressures. While many do not believe inflation is a problem, that is recency bias. The reality is that low productivity increases in recent years and massive monetary expansion have left the U.S. vulnerable should major U.S. Treasury holders start to sell at rapid rates.
While China has already sold some U.S. Treasuries the past year, it has not dumped. What if they and Saudi Arabia did dump at a time that the U.S. was trying to refinance trillions? The interest expense would jump substantially and recessionary pressures would mount.
If Saudi Arabia does indeed pump more oil this summer as I expect, then whether they sell Treasuries or not will be a telltale as to what the U.S. must do next. Don't discount that the "bond vigilantes" are waiting for a shoe or two to drop in the next year or so. "Staglation" is also lurking as I have mentioned several times in the past year.
With Saudi Arabia looking to finance its future by taking up market share for oil and taking a portion of Saudi Aramco public, it is quite clear that lowering the value of the dollar and Saudi Riyal could be in their short-term interest.
To keep the dollar from plunging too far and damaging American standard of living, the Fed is considering raising rates to protect the dollar. They, as I have discussed on MarketWatch and here, realize that in a "slow growth forever" world that strong currency is important.
Today the U.S. is at a major crossroads with Saudi Arabia, energy policy and all those impact. I don't believe for a minute that other Saudi Arabia or other nations will prioritize American interests first. We are entering an every man for himself world unless there is a sudden agreement on religion, geopolitics, energy and a hundred other issues. In other words, buckle up, it could rough soon.