The house of cards theory

A favored topic of after-hours cocktail conversations among traders and analysts on the Street is whether the dollardoom scenario is just speculation or if the greenback really is imminently vulnerable.

The crux of the issue is the current bear market bias in the U.S. dollar. And in this regard, huge “structural imbalances” — namely, the record-breaking levels of the current account deficit — is the story that just won’t go away.

As China’s inflows of U.S. dollars have grown dramatically in recent years, they’ve plowed those proceeds largely into U.S. Treasury securities. The great fear in some circles is the Chinese will abruptly sell their U.S. holdings, sparking a surge in U.S. interest rates and a plunge in the U.S. dollar.

Talk of Asian central banks pulling the plug on the U.S.- denominated investments, primarily in the U.S. Treasury market, has sparked shivers in the forex market from time to time. But most economists will tell you it is simply not in the best interests of China to sell U.S. Treasuries in large numbers.

“That’s Y-2K kind of stuff,” Buskas says. “It’s in nobody’s interest to shift direction that quickly.”

Why? First, no matter how much China trims their dollar exposure, they’ll still have dollar assets and they’d only be driving the value of their own portfolio lower. Second, higher U.S. interest rates would negatively impact American consumer spending and ultimately decrease demand for the billions of dollars of Chinese manufactured products that deluge U.S. shores each month.

“This scenario has been hanging over the dollar for many years,” says Bank of America’s Sinche. “Why would they turn around and dump dollars? It would destabilize their exchange rate. It doesn’t make any sense. It doesn’t stand up to the reality of what they are doing and what their objectives are. China’s objective is to maintain global stability. They are trying to develop economically and a big part of that is the export market. They need to have a place to sell those products.”

However, Sinche offers a scenario in which — at some point in the future — China’s internal domestic demand market has grown enough that they may no longer be concerned about external stability.