France's former President Valéry Giscard d'Estaing once dubbed the U.S. dollar's position in global financial markets as an "exorbitant privilege." In many ways, last year's global financial crisis confirmed the U.S. dollar's special status. When global financial markets were on the verge of economic collapse in September, investors scrambled for the safety of the U.S. dollar and U.S. Treasuries, and the dollar index soared from 71 to 89. But since peaking on March 4, the dollar index has fallen 11%. Ironically, good news about the economy, rallying equities and reduced volatility has prompted investors to sell their dollar assets in favor of assets denominated in other currencies. Emerging market and commodity-linked currencies have soared, with the Australian dollar, the Brazilian real and the South African rand each up at least 15% against the Greenback over the past two months.

But the U.S. dollar's current bout of weakness is about more than just a return for risk appetite. Global financial markets are getting increasingly edgy about the Obama administration's exorbitant spending plans. Standard & Poor's threat last week to downgrade the United Kingdom's coveted AAA rating only highlighted the risk to the United States. The White House recently raised its estimate for the deficit this year to a record $1.84 trillion -- about 13% of U.S. GDP. Investment bank Goldman Sachs estimates that the U.S. government will have to sell a record $3.25 trillion of debt in the current fiscal year. "Bond King" Bill Gross of Pimco has said that the markets are beginning to "anticipate the possibility" of a U.S. credit rating cut. And as Mohamed El-Erian, Gross' colleague at Pimco noted, "it's not an issue of whether the rating changes now... It's whether the markets start pricing in some change." Others like Marc Faber are less wont to mince their words. "The U.S. government for sure will go bust. That I guarantee you. Not tomorrow, but it will go bust."

The Demise of the Dollar: China's Big Problem

As the holder of over a quarter of U.S. debt held by foreigners, China is growing increasingly fearful of a U.S. dollar collapse. But China is caught between a rock and a hard place. On the one hand, China has little choice but to keep pouring the bulk of its growing reserves into the U.S. Treasuries. After all, the U.S. Treasury market remains the only market big and liquid enough to support China's huge purchases. On the other, if China shifts out of U.S. dollars in a significant way, the value of China's existing reserves could collapse. As a Nixon administration official once famously quipped: "The dollar may be our currency but it's your problem."

China's government has given no indication that it intends to reduce future purchases of U.S. Treasuries. In March alone, China's direct holdings of U.S. Treasury securities rose $23.7 billion to a record of $768 billion. At the same time, China is already altering its investment strategy in response to the U.S. dollar's expected decline. China increasingly is buying short-dated U.S. Treasuries over longer maturities, anticipating that the United States will have to raise interest rates in the medium term to combat rising inflation.

Ever the long-term thinker, China is also quietly making preparations for a post U.S. dollar era. The head of China's central bank has recently said that he hopes to see the U.S. dollar replaced as the main global reserve currency. China has set up a series of swap arrangements with other central banks, including Argentina, South Korea, Indonesia, Malaysia and Belarus, through which it will make its currency available to the other countries if they run out of foreign exchange. China and Brazil have begun talks on a scheme for bilateral trade to be settled in the renminbi and the real, rather than the U.S. dollar.

The Demise of the Dollar: Something's Gotta Give

In the past, I have been less of a bear on the U.S. dollar than many others. For all of its ostensible profligacy under the Bush administration, the United States could have trundled along at the $400 billion a year deficit level for many years. But the Obama administration's exorbitant efforts to "never waste a good crisis" as an excuse to re-shape American society in its own collectivist vision is a game changer. Obama's spending plans are simply off the charts. Even if China has no choice but to recycle the bulk of its reserves into U.S Treasuries, the sheer size of the Obama administration's expected deficit is mind numbing. Consider that the projected U.S. deficit this year alone already matches that of all of China's reserves.

So where is the money to fund Obama's vision going to come from? The answer is simple: the Fed has to print it. But buying Treasuries, mortgage-backed securities or corporate bonds to keep yields low is a mug's game. Expecting the Fed to beat the bond market is much like fighting gravity. Yes, you can overcome gravity's effects over the short term through an extraordinary and concentrated effort. But Mother Nature will prevail in the long run. The Fed pumping money into the financial system will inevitably cause both inflationary expectations and yields to rise. With l ast week's rout in U.S. Treasuries -- the biggest since June 2008 -- Treasury Secretary Timothy Geithner was prompted to tell Congress that his "basic obligation" was to put in place policies that keep confidence "in our currency, (and)... a strong dollar." You have to wonder whether Geithner himself believes his own cant. The fact that rates on U.S. Treasuries are rising during a time of global economic contraction signals that the bond market thinks that Obama's spending plans are unsustainable. And sadly, it also signals the demise of the dollar.

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