Dumping US Debt and Gold

Tuesday, March 22, 2016

Last week, CNN reported that foreign governments had been dumping US debt at record rates. What does it mean for the gold market?

Foreign Governments Dump US Debt

According to CNN, “in a bid to raise cash, foreign central banks and government institutions sold $57.2 billion of U.S. Treasury debt and other notes in January (…) That is up from $48 billion in December and the highest monthly tally on record going back to 1978”. Importantly, this is a part of a broader trend that gathered steam last year when central banks sold a record $225 billion of U.S. debt.

Why are foreign governments selling U.S. debt? Well, there are two main reasons. The first is the collapse of oil prices. In consequence, countries exposed to the oil price crash are using the cash to fill giant holes in their budgets. In other words, the petrodollar system flows are diminishing. The second reason is the economic slowdown in China. The largest owner of U.S. debt trimmed its Treasury holdings by $8.2 billion in January, according to the Treasury Department (but the actual number may be larger since China reported selling $100 billion of foreign-exchange reserves in January), in order to prevent the slowdown and stimulate the economy. As one can see, the collapse of commodity prices and the crises in emerging markets have some side effects on the U.S. economy.

Possible Consequences of US Debt Being Dumped

What could be the consequences of such sales for the U.S. economy and the gold market? Well, the intensified sales of U.S. debt will lead to a rise in the interest rates. Thanks to plenty of enthusiastic buyers and the greenback’s status as a world’s reserve currency, the federal government has been able to finance its debt at low interest rates. Higher interest rates would mean higher costs of debt servicing and would require significant spending cuts or tax increases. In both scenarios, the room for fiscal stimulus would decrease. This is important because more and more economists are now calling for a budgetary boost to the struggling global economy. However, if the interest paid on government debts jumped, the Federal Reserve would have to intervene and monetize debt. Undoubtedly, raising funds via printing money could increase inflation. The rising costs of debt payments and fiscal imbalances, as well as augmented monetary pumping and intensified inflation, would be positive for the price of gold.

Investors should not rejoice prematurely over the “inevitable collapse of the U.S. debt and the greenback”. Actually, the demand from global investors for U.S. Treasuries continues to be high and the interest rates remain to be low. The long-term rates are actually lower than a year ago (only the one-year Treasury rate has been increasing recently). And it seems that the demand for Treasuries will remain firm. Why? First, global turmoil almost always boosts safe-haven demand for U.S. debt. Second, negative interest rates in Europe (and now in Japan) make U.S. Treasuries more attractive. Investors should also not forget that the Fed is reinvesting the proceeds from its portfolio into Treasuries all the time.

Conclusions

The take-home message is that foreign governments are selling the U.S. debt at a record pace due to the collapse of commodity prices and a slowdown of their economies. However, the global demand for U.S. Treasuries remains high. This is because the U.S. economic policy looks like almost sound when compared to Europe or Japan, so the greenback is the least ugly currency in the town. This is bad news for gold since it still has to compete with the greenback for the safe-haven status. However, there is a risk that the U.S. fiscal balance will deteriorate if the Fed continues its tightening cycle. We should also not forget that either Clinton or Trump (i.e., two most probable presidential candidates) will probably increase the budget deficit. Investors should discount such a risk and factor it into the price of gold.

Arkadiusz Sieroń is the author of Sunshine Profits’ monthly Gold Market Overview report, in which he keeps subscribers up-to-date regarding key fundamental developments affecting the gold market and helps them prepare for the major changes. Arkadiusz is a certified Investment Adviser, a long-time precious metals market enthusiast, and a Ph.D. candidate. He is also a Laureate of the 6th International Vernon Smith Prize.  You can reach Arkadiusz at Sunshine Profits’ contact page.