In the former post we focussed on negative bond yields as a kind of hidden price driver for Gold. In this post we dig a little deeper.
We focus on the fundamentals of US government debt. When these fundamentals finally get into play, it will trigger the real driver for Gold: namely dollar depreciation, aka a decay of future dollar denominated paper assets. It will be the 1970’s stagflation playing out again.
In this post I address the problematic nature of US government debt. In my opinion there’s little reason to be bullish on US debt in the longer term.
The first reason to question US bonds as safe havens is their nature. It are debt promises by the US government on money that is owed, not earned. In other words; they need to be paid back one day. It is debt, not money that has been earned and saved in the real economy via profitable investments and businesses. As you may know a government does not create anything, it can only tax citizens and companies and use the tax revenue to fund MediCare, Social Security and other government programs. These programs are huge liabilities where more money goes to out to be spent than goes in to secure the future maintenance of these programs. While physical Gold is a hard asset without counter party risk, Uncle Sam is running into trouble to keep up with future promises.
Second, the US government runs big deficits, now estimated at a Federal deficit of $1 trillion under Trump while national debt has risen to $22 trillion.
Third, in order to finance all this debt, the US government issues new government bonds as short term T Bills and longer term T Notes and T Bonds. As result of years of Fed interventions in the bond market, this market functions more like a Ponzi scheme where new debt is issued in order to roll over older, already existing debt.
Fourth: foreigners are showing less appetite to buy US debt the last couple of years.
As more and more debt is issued, the amount of profitable cash flowing assets that can be taxed to pay off all this debt is behind (real economy). Another tell are citizens having more debt than savings. One of the consequences of low interest policies is that borrowing for companies is too attractive and some companies have transformed into debt consuming vehicles living on cheep credit instead of generating healthy profits. It encourages short term mal-investment and speculation (like stock buybacks), not investments in the real economy based on longer time ranges. Government borrows, citizens do and so is big corporate doing. Where are the surpluses needed to pay off the debt?
The Fed interferes in the bond market by buying bonds to push up bond prices and to suppress interest rates. And we may be closer to a point where this won’t work any longer. The repo crisis is the very sign for it. FX Empire describes the repo interference program as follows:
“To simplify, there is too little cash and too many government bonds. Well, traders can thank President Trump who has increased significantly the fiscal deficit. As the Congressional Budget Office estimated last week, the federal deficit rose 12 percent in the first quarter of fiscal year 2020 compared to the same period last year. Larger deficit means more Treasuries coming into the market, putting an upward pressure on interest rates.”
The end of the bond bull will arrive when the Fed loses control over the bond market as market forces will correct the high bond prices and raises interest rates. There are too many bonds chasing too few willing lenders. That’s why the Fed had to jump in again as lender. It used to be the lender of last resort, but it is acting more and more as a lender of first resort as infinite monetary emergency policies seem to require this.
Since the early 80’s when the bond bull began, buying the dip in US Dollar denominated paper debt assets worked as the Fed’s money creation pushed them up both while suppressing interest rates.
During the1970’s stagflation, Bond investors didn’t do well. In gold-backed dollar terms, investors who bought 10-Year U.S. Treasury Notes lost 87% of their wealth. Holders of US denoted paper assets ended up as bag holders, physical Gold and also Silver holders did well.
To understand what caused the 1970’s stagflation we have to go back to the 1940’s when Keynesians took over economic power and stuffed the Federal Reverse Balance Sheet full with Treasury bonds to fund government spending. The below figure by the Federal Reserve Bank of St. Louis & Myrmikan Capital shows the percentage of Federal Reserve liabilities backed by Gold. As the figure shows that since the 1940’s the amount of US debt backed by Gold was shrinking till the low in the early 70’s. In other words: the amount of Treasury Bonds has been expanding since 1940’s without adequate Gold backing. Then in 1971 the correction came into force: interest rates soared, bond prices collapsed and the price of Gold soared as well until the Federal Reserve’s existing liabilities was backed to 100%.
Since the low in bond prices and highs in interest rates during the early 80’s we have arrived in a look-alike situation as in 1971. The amount of issued T Bills, Notes and Bonds on the Federal Revere’s balance has increased while the backing by gold is again on a low as 1971.
Don’t think that a correction won’t happen again and that you’re safe holding a paper asset as US T Bills, Notes and Bonds. You risk to become (again) a bag holder of future dollars that are already spend by the government on programs and subsidies that won’t generate a durable, long lasting cash flow.