Recently there have been a plethora of articles delving into all the complexities of the US bond market. For this reason, I am going to keep this article short and simple.
US deficit spending ensures future Treasury bond issuance in the weeks, months, and years ahead as far as the eye can see (and then some). The US will depend on foreigners to purchase the debt. However, foreigners are becoming fully aware that the US economy is built on a foundation dependent on a commodity (oil) which will become increasingly expensive and which the US not only uses 25% of the world's output, but imports 65% of it. At current prices, the US is spending $840,000,000 a day for foreign petroleum imports. This works out to $306,600,000,000 a year. That's a lot of zeros isn't it? Double that number when oil goes back to $140/barrel.
What does this have to do with US Treasury bonds? Well, I ask the simple question: why would the governments of China, Russia, Saudi Arabia, and Brazil want to be holding US debt when there is such an obvious economic weakness as the US's dependence on foreign oil imports? Further, why would these countries continue to do so in the future when the see no strategic long-term comprehensive energy policy from the US government to solve the oil problem?
This past week, US equity markets breathed a heavy sigh of relief when 30 year treasury issuance was well received by foreigners. However, as the price of oil rises in the future, will foreigners become increasingly wary of investing in long term US bonds? If so, bond interest rates will have to rise to entice them to purchase. At the same time, an increase in oil prices will cause US economic weakness which will be reflected in further US currency depreciation. Since oil is priced in US dollars the world over (at least for now...), this will be a tailwind for even higher oil prices and we reach a condition that electrical engineers refer to as thermal runaway: resistance in a circuit normally increases as the circuit gets hotter. As the circuit gets hotter still, the resistance of the circuit increases further leading to more heat and we have a self-reinforcing mechanism that eventually can lead to a serious malfunction if prudent design principals are not followed. The analogy is the exactly the same for US debt, oil prices, and energy policy with the result that it is the US economy which is likely to malfunction.
It is no surprise that China has been slowly exchanging long-term US Treasuries for shorter term debt. It is also no surprise that other countries holding US Treasuries have been unusually vocal about US financial policies. When the BRIC countries hold their first summit Tuesday in the Ural mountains of Russia, expect the leaders of Brazil, Russia, India, and China to continue to propose moving away from the US dollar as the world's reserve currency. These countries realize the danger of a world economy based on the currency of a single nation that has such a large economic dependence on foreign oil imports.
The US cannot solve a commodity problem (oil) with financial trickery such as the Federal Reserve stepping in to buy long term treasury notes. The only solution to US economic problems is a long-term energy policy of which the central theme should be to significantly reduce foreign oil imports by transitioning to natural gas transportation fueled by US produced natural gas. Please read some of my articles explaining why this is possible and why the US should do it:
The US has the natural gas reserves. We have the NGV technology. All that we need to do is replace wrong-headed energy policy like "cash for clunkers" with sound long-term energy initiatives to move away from gasoline derived from foreign oil.
US investors should be aware of the link between oil and US Treasuries and stay away from them unless buying something like the TBT (Proshares UltraShort 20+ Year US Treasuries ETF).
Instead, US investors should protect themselves from higher oil prices, a falling US dollar, and coming high inflation by buying energy and energy service stocks like XOM, CVX, COP, PBR, BP, STO, and RIG. Also, every American should own some gold in an environment as risky as the one we are in today. Some like GLD, but that is a paper asset and you might want some gold coins to bury out in the back yard. Of course, if the US economy completely implodes I doubt any investment will protect Americans from what could happen. The best protection from this happening is for Americans to support natural gas transportation and push your elected officials to support initiatives like HR 1835 and to be more proactive in crafting prudent long-term comprehensive energy policies.
Disclosure: The author owns COP, PBR, STO and is long gold.