The U.S. government sells a whole lot of bonds every month, and since Americans are reluctant to save on a meaningful level, foreign interests purchase many of these bonds. In fact an average of nearly thirty billion dollars of Treasury bonds have been sold abroad in each of the last 18 months on record. But there is a surprising shift taking place in who is buying these bonds, which should be of interest to us as investors, and as Americans.

Since early 2004 there has been a gradual decline in the monthly purchase of U.S. Treasury bonds by foreign governments. In fact since the first of this year foreign governments have purchased an average of only $5 billion in T-Bonds each month. This represents only 29% of the level of their average bond purchases during the calendar year 2004.

This leads to two questions:

  1. What are foreign governments doing with their trade-won dollars if they are buying fewer T-Bonds?
  2. Who is buying these bonds if not foreign governments?

Where are foreign trade dollars going?

China, Japan, Canada and Germany, our top four trading partners, all have substantial positive balances of trade with the United States. In fact, these four countries account for roughly 50% of our trade deficit, so it’s a useful speculation for us to consider their use of U.S. dollars.

In the case of China, the consensus is that they are shifting dollars toward the purchase of raw materials (i.e.; commodities, including oil), as well as an ongoing interest in purchasing businesses in the United States. Japan and Germany are also substantial commodity importers, and there are indications that Japan has an increasing interest in the purchase of gold. There has been a surging demand for gold as an investment among Japanese consumers for several years because it acts as an alternative to the nearly non-existent return on Japanese bonds. The Japanese government is in a position to use U.S. currency to purchase gold on the international market to satisfy their domestic gold demand.

Canada as a resource based economy has no need for significant commodity purchases, but because of NAFTA, Canadian controlled U.S. dollars flow smoothly back into the United States in a wide variety of investments. In fact, most Americans are so enamored with our Cannuck cousins, we’d be happy to sell them any piece of our economy they want to buy. Why worry about a bunch of toothless cheerful hockey players when we can rail against the Red-Menace, right? (But I digress. I need to save my exposition on Canada’s relative economic success, as well as my views on Sino-phobia, for another day.)

In general, the most provocative aspect of the decline in foreign government investment in U.S. T-Bonds is how it may be a driving force in the oil, gold and commodity markets. In a previous article on energy, I remarked on how the tendency of many nations to develop and/or increase strategic oil reserves is tantamount to hoarding. I don’t think that’s an unusual or even imprudent response to the rapidly increasing price of any commodity, but as a pervasive attitude of scarcity permeates the energy markets, the act of hoarding becomes competitively nationalistic as it encourages further price increases in the world market for that commodity. Here again in the current market, it seems only natural that oil and oil resources become an attractive alternative to T-bonds. Since commodities markets are generally priced in U.S. dollars, they provide a ready place for our trade partners to utilize accumulated U.S. currency. And since many countries are losing confidence in the U.S. dollar, spending dollars on oil is a good way to pass some bucks.

If you’re still not convinced about the T-bond vs. commodity price relationship, just take a look at the accompanying chart. It indicates the marked increase in the price of basic commodities, as reflected by the price trend of a popular commodity fund, during the same eighteen-month time frame when foreign government investment in T-bonds has been decreasing. Looking at it this way, there seems little doubt that our trade partners are learning the lesson that investing in “stuff”, including oil and gold, offers much better return on investment than U.S. Treasury securities, and in the process they are helping to fuel escalating commodity prices.

But who is buying Treasury Bonds?

When you realize foreign governments aren’t buying T-Bonds like they used to, you should start to wonder who is, because that’s who is funding the current account deficit now. It requires a little speculation to surmise exactly who this might be. This year the major purchases have come through London, and to an even greater extent, the Caribbean. These are two centers of international finance and thus, it is doubtful that either area is originating these purchases. If I was a bettin’ man, which I am, my money would be that the U.S. Treasury is the benefactor of Arab oil profits. Due to U.S. scrutiny of the politics of all Arab investors, the only safe access these Oil Barons have to the American securities market is through offshore banks. There are incredible profits being made at the current price of oil. The security of that money is what is important to its owners, not necessarily the return on investment, so

Treasury Bonds are a good fit.

Another potentially surprising source of funds for T-Bonds is through the foreign activities of U.S. corporations. We are well aware that many U.S. companies have expanding operations in emerging economies. What some may not be aware of is the extent to which U.S. corporations can form shell companies in the Cayman Islands and other tax-haven domiciles where they can quite legally avoid U.S. taxes as long as they don’t bring these dollars back into the United States. As an example, IBM recently repatriated $9 billion in earnings from foreign subsidiaries under a temporary tax amnesty provision, and IBM is just one example of the magnitude of holdings U.S. companies retain overseas. It’s quite possible that a significant amount of foreign-originated purchases of T-bonds may be at the behest of U.S. corporations. I don’t want to carry what is largely a hypothesis to the absurd, but I would like to point out that the U.S. foreign account deficit might be over-stated to whatever extent U.S. companies are preserving profits offshore and reinvesting profits in the U.S. economy through T-Bond purchases made by their foreign subsidiaries. Where are the investment opportunities here?

In any economic discussion we are most interested in the impact on our investments and our fiscal opportunities. Here we find that foreign governments are less interested in T-Bonds. Consequently, so are we. These same governments have elevated interest in gold, oil, and other commodities. All three of these areas have established positive trends for us to remain invested which, I might point out, softens the impact rising prices of these commodities have on our day-to-day lives.
Arab oil producers are making lots of money; so let them buy the T-bonds, but understand that this investment in the U.S. economy impacts the natural cycle which I believe, in spite of my previous writings to the contrary, means the current account deficit may be sustainable for several more years. Played out it goes like this: the price of oil will likely continue to rise as there is serious doubt in the market that supplies can keep up with increasing worldwide demand. This trend is creating a massive accumulation of capital among oil producers. Many of these producers opt for the relative security of U.S. T-Bonds because safety is of greater concern to them than further capital gains. The U.S. current account deficit remains sustainable as long as there is a countervailing flow of capital into the U.S. economy. Of course if the Arabic component of T-Bond purchasers really get annoyed over some political or religious issue they could suddenly decide to take their dollars and go home. That would be an economic disruption on the order of the 70’s energy crisis. In some ways this is more worrisome than the T-Bond holdings of Asian banks (of which I have waxed on about in previous articles). Asian central banking interests are at least concerned enough about their countries’ own financial health to avoid intentionally throwing the world into a recession.

For now, the best way for each of us as individual investors to protect ourselves is to follow the dominant trends. Resource demand both domestically and in emerging markets is going to continue to rise. No one believes that oil will be cheaper five years from now than it is today, and in this particular case, I’m not enough of a contrarian to take the other side. Monetarily I like gold too, but most of the gold ever mined is still around today. The consumable resource commodities appear to me to deserve even greater position than gold in a dynamic portfolio.

I tried to get through this piece without an element of foreboding, but somehow one just squeezed itself out. So my advice is this: to know what is going to happen next, you have to know who controls the puppets. It’s a bit uncomfortable to be forced to guess who’s loaning our government piles of money, but if my guesses are right, we could someday once again be experiencing the law of unintended consequences.

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