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More Debt, not Less

By Paul van Eeden
April 7, 2006

www.paulvaneeden.com

Mr. Hu Jintao, the Chinese President, is scheduled to visit Washington later this month while the United States continues to put pressure on China to let its currency appreciate against the dollar. It seems China is going to comply:

In December Mr. Yu Yongding, who is a member of the monetary policy advisory committee to the People's Bank of China, said that China should weaken the link between the yuan (renminbi) and the US dollar, to make the exchange rate more flexible and improve the (Chinese) government's ability to manage the economy. Mr. Yu suggested that the weighting of the US dollar in the basket of currencies against which the renminbi is set should be reduced; thereby reducing the impact that changes in the US dollar would have on the value of the renminbi. Mr. Yu also said that Chinese firms should get ready for a strengthening of the yuan in the next one to two years. The "fuller the preparations, the better," he said.

In January China said that it would allow interbank spot trading (i.e. not futures trading) of its currency - a major step towards a less restricted foreign exchange regime in China.

Another significant announcement came from China’s State Administration of Foreign Exchange (SAFE) that said China should diversify its massive foreign exchange holdings, which are predominantly held in US dollars. SAFE gave no specifics and no hint as to any kind of timetable, but this is not the first time that we have heard such rhetoric from Asia.

The BBC reported this week that Chinese Parliamentary vice-chairman Cheng Siwei suggested China might reduce the amount of US bonds it holds as part of its foreign exchange reserves. China’s Central Bank was quick to point out that Mr. Cheng was speaking in his private capacity; however, with President Hu Jintao’s imminent visit to Washington I find it hard to believe that Mr. Cheng’s opinion is an aberrant opinion. His remarks led to a decline in the US dollar and a concomitant increase in the gold price this week. Gold is within spitting distance of $600 an ounce.

Perhaps less widely publicized, but potentially far more important, is the increase in long-term US interest rates. The benchmark 10-year Treasury fell this week causing the 10-year interest rate to rise to 4.971% - a four year high.

Why are US bonds falling, causing interest rates to rise? Because if the Chinese allow their currency to appreciate against the dollar it implies reduced purchases of US Treasuries by China. Japan has already curtailed its purchases of US Treasuries and, in fact, Japans holding of US Treasuries is busy declining.

The mechanism by which China and Japan have been supporting the US dollar is to buy US Treasuries instead of selling US dollars into foreign exchange markets. If they are forced by Washington to let the dollar fall, it means they will have to buy less US Treasuries; hence, a falling US dollar will go hand-in-hand with rising US interest rates, exactly what has been happening recently - and as predicted in these pages.

Note, however, that it is not short-term interest rates, over which the Federal Reserve has considerable control that we are looking at; it is longer term interest rates, which are set by the market, that will tell us what is going on.

An aspect of the current situation that is being ignored is that US government debt is about to explode. Rising interest rates mean the interest burden on US debt is rising. But, higher interest rates will put a drag on the economy and I do not, for a minute, believe that the current jobless economic expansion is going to last. I am afraid that a more realistic expectation is a slowdown in economic activity, which will lead to reduced tax receipts by the US government. In addition, there is no reason, whatsoever, to think that the US government is about to curtail its spending; rather, if the economy does slow down, there is some reason to believe the government will try to stimulate it by increasing its deficit spending. Thus we are looking at reduced income for the US Treasury in the future and an increase in government expenditures and a higher interest burden on the burgeoning outstanding Treasury debt.

Many people pooh-pooh the US debt situation. Let me try to put it in context for you. The US Treasury has a hair under $8.4 trillion in outstanding debt. Did you know that if you deposited one million dollars into a bank account every day, starting 2006 years ago, that you would still not even have ONE trillion dollars in that account. If you deposit one million dollars into a bank account every day it would take 23,000 years to accumulate $8.4 trillion dollars.

Maybe you don’t like to think that far into the future. Perhaps a trillion is just too big a number to comprehend, so let’s think about billions. During the past six months, since the beginning of the current fiscal year, the US government’s debt has increased by $456 billion. On an annualized basis that is $912 billion. The US government’s debt increases at the rate of $2.5 billion per day, including weekends. How much is a billion? A billion seconds ago it was 1974 and one billion minutes ago Jesus may still have been alive. Next time someone tosses the word “billion” or “trillion” around casually you should ask if they actually know how much it is.

It might be true that the US economy is very large, and many people believe the US economy is large enough to carry the humungous amount of US debt. Personally I believe that US economic growth is overstated but, even if we assume the official numbers are correct, then US economic growth is only about 2% to 3% per year. The US government’s debt is currently growing at an annualized rate of 11.5% and, as I explained earlier, that growth rate is about increase.

The amount, and the growth rate of US government debt, coupled with the possibility that China will have to reduce its purchases of US Treasuries to comply with the wishes of Washington, means that US interest rates could soar. Again, we are not talking about short-term rates here, but longer-term rates: The five-year rate on which auto financings are based, and the twenty and thirty-year rates on which mortgage rates are based. This is bound to hurt US consumers, corporations and the US economy and it will occur in conjunction with a weakening US dollar, which means higher gasoline prices.

A weaker dollar also means higher gold prices.

Paul van Eeden

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Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

 

 

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