FOOD FOR THOUGHT: Long Bonds Or Bust

Tuesday, November 24th, 2009

One of my clients asked me a good question on Friday. How in the world can this bond market continue higher? It appears to me that there is still an appetite for U.S. Government paper in the short run, mostly because there is still an active camp of deflation supporters. It is a very strange time in the markets these days, as one can make a case for further deflation in the short run as well as serious inflation in the long run.

In any event, I thought I would comment on a few things that will eventually have a great impact on the dollar, and the U.S. Government bond market.

It is no mystery that we are printing money like it is going out of style, but what might escape us is just how much short term debt we have accumulated. According to several sources the Treasury will have to refinance $2 trillion in short term debt over the next 2 years. This is exclusive of any additional deficit spending which could be another $1.5 trillion. That totals $3.5 trillion, yes that’s trillion, dollars. A better question would be, how in the world can we borrow 3.5 trillion dollars over the next year?

Porter Stansberry said in a recent article “that’s an amount that is nearly 30% of our entire GDP. And we’re the world’s biggest economy. Where will the money come from?”

He also shared where if a country is to stay solvent, they should maintain reserves that equal 100% of short-term external debt.

Porter went on to say, “The U.S. holds gold, oil, and foreign currency in reserve. The U.S. has 8,133.5 metric tons of gold (it is the world’s largest holder). That’s 16,267,000 pounds. At current dollar values, it’s worth around $300 billion. The U.S. strategic petroleum reserve shows a current total position of 725 million barrels. At current dollar prices, that’s roughly $58 billion worth of oil. And according to the IMF, the U.S. has $136 billion in foreign currency reserves. So altogether… that’s around $500 billion of reserves.”

“Our short-term foreign debts are far bigger. According to the U.S. Treasury, $2 trillion worth of debt will mature in the next 12 months. So looking only at short-term debt, we know the Treasury will have to finance at least $2 trillion worth of maturing debt in the next 12 months. That might not cause a crisis if we were still funding our national debt internally. But since 1985, we’ve been a net debtor to the world. Today, foreigners own 44% of all our debts, which means we owe foreign creditors at least $880 billion in the next 12 months – an amount far larger than our reserves.”

Some large central banks like China, Russia and India have already slowed down their purchases of U.S. debt and have been buying more gold. Recently China reduced their position by $35.1 billion (3.89%), Russia by $4.6 billion (3.69%), and the Caribbean Banking Centers (4th largest foreign holder of UST’s) by $5.1 billion (2.6%). I think there is a good chance other central banks like Brazil and Chile might follow, considering they own very little gold. This would cause the U.S. to print even more money to refinance the debt.

Well, to say the least, this is not good for bond prices in the long run.

In the short run however, the ratio of the money supply to the GDP has been deteriorating and is now at historic lows, indicating a low velocity of money (the speed at which money changes hands) which supports the deflation scenario.

Chart