US Debt Issuance and Gold Price

Fang Li, University of Virginia 6/20/2013

US debt issuance has been increasing since 2000. Treasury debt increases modestly after 2001

Treasury Debt
3000.0 2000.0 1000.0 0.0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Treasury Financials
4,000,000 3,000,000 2,000,000 1,000,000

Treasury

Receipts

Outlays

due to reasons of Iraq war. It is also reflected on the right chart that American government spending increases after 2001 (1.86 trillion) to 2003 (2.29) trillion dollars which is a huge increase. Government receiving however decreases by 100 billion. At the background of a bad economy and government revenue, Iraq war started. During 2001 to 2004, Government changed the trend of having positive net revenue. 800 billion has to be financed at an interest rate of 4% (10-year) or 1%(1-year) Fed contributes to the low cost of US government borrowing. Although US treasury debt soars 381 to 853, the problem was not so severe as it is still a small fraction of GDP. But this drastic increase in government spending enlarges the size of the total US economy, causing the impossibility of the government spending dropping. The boost increases the revenue as well, though; it cant reach the speed of the spending mounting. A debt-addicted economy has formed.

How a debt-addicted economy has formed

Besides individual investors, trust funds, etc. Foreign investors expanded interest in treasury debt. Holdings increased by 500 billion dollars during this period. So the 800 billion was soon digested without causing the market fluctuate and a Fed move. Things are quite different in the 2007 financial crisis. US debt has almost doubled during this period, international investors dumped in 2 more trillion dollars to help save the US economy. This is unprecedented and keeping the interest rate extremely low. This is due to mainly the fast developing countries are willing to see a recovery in US economy so that they can continue exporting to the US as we can see China is holding more than 1 trillion dollars treasury debt (about 1.3) and has roughly 3 trillion dollars reserves. Japan follows China. The two countries almost share half of all the worlds holding of US debt. Why? Because, but keeping a strong dollar, their export can contrinue drive their own economy. If No one buys the debt, it will cause a week US dollar and the depreciation will lead to a decrease in those countries competency in trading with US. The States is a single biggest consuming market with its consumption 6% more than its income. The 2007 financial crisis has greatly changed the US debt landscape. The debt crisis in 2011 is just a reflection of this change. In order to finance the huge deficit during the years Total 2002 2003 2004 2005 2006 2007 -1,675,298 -157,758 -377,585 -412,727 -318,346 -248,181 -160,701 2008 2009 2010 2011 2012 -458,553 -1,412,688 -1,294,373 -1,299,593 -1,086,963 The total deficit from 2002 to 2012 is 1.68 trillion dollars. The size of US debt increases drastically not only because of the deficit but also the expanded economy. It seems that US debt is almost out of control. But take a look at the following chart. Total interest payment by treasury fluctuates around the period without changing much. A decrease from 2001 to 2004 reflects the

treasury is more willing to borrow short-term debt because of the low cost of short term debt. Another factor would be the astonishing 10%+ long term bond has been retired by a large scale. The interest rate for government bond reaches the peak of recent history to 14% to 15% during the 1981-1983 financial crises. A modest increasing from 746 billion in 2005 to 1037 billion dollars issuance by 2008 (40%) only leads to an increase from 352 billion to 452 billion (30%) dollars interest payment during the same period. The heavy burdens of the past debt are gradually unloaded during this period.

Total Interest
500,000 450,000 400,000 350,000 300,000 250,000 200,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Total Interest

Treasury Interest rate

6.0 5.0 4.0 3.0 2.0 1.0 0.0 80.0 60.0 40.0 20.0 0.0

Interest Payment /year

2005

2001

2002

2003

2004

2006

2007

2008

2009

2010

2011

2012

3-month rate

10-year rate

3-month

10-year

The above right chart is how much the treasury has to pay if all the debt it issues is 3-month or 10-year note. Its an imaginary chart but it gives an upper bond and lower bond. 3 Reasons explain why we see a drop in total interest treasury made. 1. Old debt retired. Financial burdens are more relieved. 2. Recent debt is paying normally. 3. New debt asks even less interest payment though the size increases a lot. By controlling interest rate, government and the Fed has enough money to inject into financial system for the multi bail-out plan.

2012

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

But take a look at the treasury size chart. New debt issuance stands firm above 2000 billion annually, reaching as many as 2300. We can almost consider that the Fed carefully select the interest rate to let the US fall into a liquidity trap and then help the government use fiscal policy to stimulate the economy.

A liquidity trap, according to IS-LM model in classical Keynes economy, is a state when monetary policy doesnt work at all. Because the interest rate is too low, the increase in money supply will not lead to credit boom. No banks are willing to lend because its not worth the trouble to shoulder the risk premium and earn a return so low. But if this is the case, the government spending is helpful in increasing the total output. So because of the liquidity trap, we can almost see that the printing money method will not likely work here to stimulate the economy. Then we see that combined with monetary policy, government also increases spending to stimulate the economy. The result is a fast increasing outlay and huge deficit.

The recovery process is slow however. Unemployment rate stays above 7.5% for a long time. This requires time and constant stimulus plan. But we should put a question mark on how well public want to hold this low interest rate bond although, at current extremely low interest rate. On the borrowers side, we don't see much space for fiscal cut. The sequestration will not continue much especially currently that education, national defense and health care are already been cut heavily. The top components of government spending are: national defense, Health&Medicare, income&social security and interest payment, consisting 2 thirds of total debt. Future cut will come from national defense mainly but not much. So, staying at this level of budget, the government is unlikely able to afford a huge cut in debt borrowing. When the economy recovers, more money will be invested in alternative investments such as real estate, stocks and so on. Yield will rise. So, its really cold after the snow. Government will pay much higher if it doesnt cut its spending. From history however, government might learn that increasing spending will not cause the interest paying rise if interest rate is low. And the unloading process of the past high-interest debt helps the interest payment low so the total interest payment is low. However, things are changing. This time, history might not tell the truth. Since 2001, interest rate has never rise above 5 percent and short term rate is almost at all-time below 3 percent. The interest payment structure is more determined by the size instead of interest rate. So what will happen next? The economy is recovering, no matter fast or slow, Dow and S&P500 has reached historical high indicating a better economic forecast and good investment opportunity in risky assets. Real estate has also returned from the low in 2009. University of Michigan Consumer Sentiment has also recovered from a low in 2008. From the above GDP, we see a right track.

We can anticipate if America is truly recovering, the interest rate on either long-term or shortterm will increase, adding heavier burden on the interest payment. With old debt effect gradually quitting, the interest payment will soar soon. If we assume the interest will return to 2008 level, in the middle of the crisis, then the interest payment will double within 10 years, and treasury

debt will also soar. America cannot play this game forever. Without a new industry revolution, this cant last forever, not even until 2020. The ever increasing public debt will force the Fed to print more money to hold these bonds because foreigners are more reluctant to increase their dollar asset. This doesnt not imply they will return their dollar asset. It simply says that no one is willing to pay for the increase in the debt size. So, the interest rate will rise to a new equilibrium level. Maybe the number is not too high, around 3 or 5 for long term debt and 1 percent for short term debt. But this is enough to change the debt landscape again. The United States government will have to pay much more than before to pay for the interest each year. In order to cool things down, the Fed will have to again use its monetary power to keep interest as low as it can. More money will be printed for sure. The potential risk of this action is the ever high equity price and reluctance of holding dollars. Dollar will become a less favorable fiat money and the world structure will be forever changed. This seems far away from us, but when it happens, it happens really fast. Historically, there is a financial crisis every ten years. If the Fed keeps the interest rate low as now, it will be like Japan and have no methods to stimulate next financial crisis without further expand government spending. And the Fed once more will be forced to buy bonds. The whole point is whether the public and foreign investors are willing to take debt, forever. And the answer is NO.

Why gold is the only choice

From the above analysis, we can see this fiscal expansion is largely due to the 2007 financial crisis. Here we spend some time recap what happened before from a perspective of all the possible investment opportunities. Prior to the crisis, the world market worth roughly 140 trillion, with 96 trillion dollars in stocks and bonds. Gold is only 3.4 trillion. We can see if we use gold as money base, we will experience a significant credit extraction and the world will collapse. So, gold is not money. Dont even think about it. But Current world currency system is completely based on the government credit. If people lose faith in the government, nothing could save a scary inflation as that happened in Zimbabwe. But the question is what else can you believe? You can trust real estate, land, farm, etc. All are what will not change in the future. We want some things for sure, lasting eternally. There is a reason why diamond is expensive, because they are shiny and last forever. Gold is the same. Gold is not something that gives you cash flow, dividend, interest or anything. But gold is an important alternative trust. No one really with whole heart trust strangers, then why should we believe our government? It is because we elected them. But we dont elect Ben Bernanke. Sometimes, the Fed is far more favorable to sacrifice ordinary peoples interest to help US economy. Especially when a crisis happens, the Fed changed completely to a printing machine. Much liquidity is injected in the financial system and push down dollar value hoping to increase loan and export. But theres not much effect. The severity of this 2007 financial crisis exceeds far more than the ordinary financial extraction. So, the interest rate is zero and government spending is enlarged. Though, this cant help the equity

market and bond market. People see you are making an effort, but people do not believe this economy will recover soon. With lots of firms going bankruptcy, why the heck would I buy the stock that could turn to be a piece of paper tomorrow? The answer is clearly no. I would like to find something else that I can trust. Maybe Euro? Nah Euro is a last option at the moment because of the financial crisis it is experiencing. Yen? Probably not, Japanese economy has been stuck in where it was since 1990, and its central bank keeps its interest rate close to zero. If we look around and find no appropriate currency we can rely on (Dollar index drops to around 80, historically low level), then we will not seek a currency alternative, we will turn to things! All right, we did jump a little far, what about Chinese Yuan. Speaking of reliability and expected return, Yuan is a pretty good choice. But the idealism difference and a strong doubt about the communist party affect investors mind. Whats more important, its too hard to flood China with foreign investment because Chinese government controls capital flow really tight. China chose to leave capital control on the impossible triangle and practice its ability to influence the capital market. So, what do we have now? Real estate? Depreciating. Stock? Bear Market. Corporate Debt? Too risky. Other countries debt? Come on. So literally we have nowhere to go. The only choice is gold.

Gold Demand and Preference

Peoples preference for this precious metal doesnt change much. With the total wealth growing, especially the Asian economy booming recently, this per ounce data should be growing at some space. But what we see here is that it doesnt change much after 1978, the fall of Bretton Woods System. But the trend is clear and sound.

gold/world
28 26 24 22 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 36 34 32 30 28 1950

gold/non-poverty

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

gold/world

gold/non-poverty

2010

Gold per capita growth in history

4.00% 3.00% 2.00% 1.00% 0.00% 1955 -1.00% -2.00% -3.00% -4.00% gold/world gold/non-poverty 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

So, the wealthy peoples preference for gold has never changed. From the chart of worlds population, we can see that worlds population is faster than the growth of the not-poor people. The worlds poverty war is even further from ending because China contributes to a large scale of the recent gain in solving the poverty problem. And in the future, this is unlikely to happen again and due to that Africa will continue to have large population growth; our earth will experience more and more poor people. The war of fighting the poor will have the major battlefield in Africa. But thats not our business. Peoples demand for gold will not grow too fast in the future as population will not increase a lot and the world production is expected to drop.

World Population
8000 6000 4000 2000 0

Growth every 5 years

15.00% 10.00% 5.00% 0.00% 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

World

World(non-poverty)

world

world(non-poverty)

Gold Production and Cost

Our prediction of gold production also matters, but not much.

In 2008, the price is about 800 to 900 dollars per ounce, and we see from graph that per ounce cost is about 440 for the median level. Though the median is rising, it is impossible to catch the speed of the price rising. That means considering gold as a simple commodity would be a wrong approach to analyze this problem. What we need to consider is the production cost other than pure mining cost, including exchange loss, administration, marketing and so on. We see a more updated graph. The major gold providers total cost for an ounce of gold ranges from 919 to 1135. An average would be around 1000 dollars/oz. And now the price is not so high above the cost. We can see that if gold price hit below 1200 dollars, Goldcorp will cease to produce, especially from those high-cost mines. Although Barrick will continue to produce, it will also close the mines with cost over 1100 dollars cost. So the production will drop much and wait until next financial crisis. Now, as the US is continuing quitting the quantitative easing, the price of gold is expected to drop in several years. So, we would expect that the gold production to drop as well. However, this analysis doesnt imply this trend in gold production will revert the price and

make it rise; the production is always behind the price change. What the production can affect is to slow things down. The price will not drop easily. 1200 is an extremely strong supporting point.

Debt US treasury interest rate payment pressure is shown in the graph below. Long-term bond pressure always exists from 2005 and remains relatively constant these years and further prove that historical burden is unloaded for the long-term bond. We can forget about the 1980s high interest payment and start a new era.

Interest Rate Payment Pressure

200,000 150,000 100,000 50,000 0 Dec-99 Dec-04

Total Debt Burden

300,000 250,000 200,000 150,000 100,000

Mar-01

Mar-06

Dec-09

Jun-02

Sep-98

Jun-07

Mar-11

Sep-03

Sep-08

Dec-99

Dec-04

Jun-07

Mar-01

Mar-06

Dec-09

Jun-02

Bill

Note

Bond

Series1

From the total debt burden, we can see that after 2005, the shape is almost the copy from the shape of treasury bill. And we know that treasury bill accounts for an average of 82% of total treaury debt from 2001. (81.9195%) We can basically say that the government is borrowing for no cost, or at least, not more than what it had to pay in history.

Mar-11

Sep-98

Sep-03

Sep-08

100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 Jan-82 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09

18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%

Jul-95

Jul-80

Jul-83

Jul-86

Jul-89

Jul-92

Jul-98

Jul-01

Jul-04

Jul-07

Bi-int(6)

interest rate

After 2007 financial crisis, the American government again expanded their balance sheet in a large scale. We see that the total debt is hitting the historical high and treasury debt issuance is hitting another high as well. With the economy going better, interest rate will continue to rise. No one is willing to lend to government at such a low cost anymore. What will happen is that the tax revenue income increase will not be able to compensate the rise in the interest rate. The debt will be issued more and more. But will the Fed pay the bill? No, probably not. The Fed has printed enough money to frighten the international investors. If its going to purchase more, American money credit will be abandoned. So we will see a peaceful rise in the government debt and an increasing interest burden. As we will discover from the graph on this page, the interest payment is more and more sensitive to the interest rate change. This is due to the ever increasing size of the debt. An interest rate increase from 2 percent to five percent increased American debt to a historical level with short term payment being 90 billion monthly and total debts 250,000 monthly. We know the government always favors short term debt because it has to pay much less interest rate. But this time, it has to pay much more than it can stand. A financial crisis is ahead of time.

Jul-10

debt issuance(12 m avg)

700,000.0 600,000.0 500,000.0 400,000.0 300,000.0 200,000.0 100,000.0 0.0 16,000.0 14,000.0 12,000.0 10,000.0 8,000.0 6,000.0 4,000.0 2,000.0 0.0

May-02

May-04

May-06

May-08

May-10

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Sep-01

Sep-03

Sep-05

Sep-07

Sep-09

Jan-11

bill

note

bond

Willingness to buy We should really see who bought and will purchase the treasury more. Right now, 48 percent of the debt is held by foreigners, 30 percent of the debt is held by social security agencies. With the coming credit boom, who can pay the bill? Will these governments and social agencies pay for that? No. Why? Because they don't have the money to catch up how the public debt increases. And as the economy gets better, the interest rate on these debts is too low. Will foreigners still pumping money? No. Why? Because Chinas economy will slow down and so will other major developing countries. If Africa is not rising as what happened in China, then there is nobody rich enough to purchase the treasury debt at such scale as China and doesnt demand a return. No one will be able to buy the debt. But the economy should get better, interest rate face the pressure of going up but government cant afford that. What? What will happen? Oh my god, does that mean the AAA bond will default? The answer is probably not. Dont ignore the existence of the Federal Reserve, the best printing business in the world. America cant default. It certainly cant afford a sharp rise in interest rate. The president will force the Fed buy the bond and print more money. The independence of the central bank will again be put into a question. Well, this is only assuming if government spending doesn't go down and revenue doesnt go up. But thats not the case; America is considering taxing on the E-commerce and some largest issues. Also, it will spend some more time and effort in fighting these tax havens to bring tax back. Spending will be further cut.

Sep-11

I will argue here this is not enough assuming theres no industrial revolution. I mean the kind of revolution as the discovery of internet or maybe a new energy could save it. Fed buying QE4 is about the Fed buying 40 billion treasury debt per month, what is the Feds role? We can observe that whenever there is a financial crisis, the Fed will lower its rate. How does this help the government? So, what the government has to do is to spend a lot more to stimulate the economy. The Keynesian economy says Y = C + I + G. the consumption and investment are largely depended on the interest rate. Specifically the in the United States, consumption and investment are negatively related to the interest rate, because Americans are financing to consume and invest. So the interest rate should drop to make the GDP larger. Also, a lower rate will help the government finance. If the Fed cant help keeping the rate low, the government will have to finance heavily. And they have to go bankrupt. But that is not the case; the Fed will not leave it alone. The fed will set a lower rate in order to improve the bank liquidity.

Case Study: American Fiscal Cliff

This is the chart from December 19th, 2012 to January 2nd, 2013. The sudden drop is due to a positive forecast by the market on December 20th because bipartisan political figures came on stage expressing their confidence in the plan B. From 21 to 26th, its Christmas, the market slow covers the drop at 1657. As the combat goes on after their vacation, the fear of the fiscal cliff continues to take effect. Gold soars around 250 pips. And after their agreement and the bill getting passed in the House, the gold price drops 600 pips. The fiscal cliff actually is not about debt; instead it is about debt ceiling. This event reflects a hard choice between two political parties attitudes on cutting spending. The debt ceiling has to be increased.

Analyzing this event, the market believes the fiscal cliff will be settled because America cant default. So their positive attitude is combined with a little, very small concern about the potential default risk. The market is taking some steps out but slowly. Prediction Now, lets make some bold prediction about what will happen in the future. As the treasurys balance sheet has little hope of dropping, if we assume the debt issuance is not increasing and interest rate increase to around 1 percent. The total interest burden will rise to around 350 billion annually. A 2 percent short rate will cause a whopping 490 billion interest per year and a 2.5 percent will lead to a 600 billion, 16% of the 2013s total outlay and 22% of the 2013s total income. (It is increasing more slowly because the term structure will change over time as economy gets better, the term difference will be narrowed) Imagine that when American government has to pay the debt of 600 billion per year! No one is able to afford that. The government has to keep the interest rate low! America is heading to a Japanese way. When this will happen? Ben Bernanke said the Fed will gradually quit QE4 starting the end of the year if everything goes well as he estimates; QE4 will end in June 2014. Lets suppose thats true. As the bond buying program will indeed have impact on the interest rate, especially on the short term rate. The short term rate will not soar until the Fed really quit the program. So, lets say the short term rate will start going up in January 2014. As history suggests, the interest rate price will gradually increase. It will take around a year and a half to recover 2 percent. So, by the end of 2016, the interest rate will be more than 2 percent. 2.6% short term interest rate is not so unlikely to happen. And then, the interest rate American government has to pay each month will be no less than 350 billion dollars per month and 4.2 trillion dollars per year! That's 25 percent of total GDP today! If we assume that GDP grows at 10% annually nominally, by that time, it will be 20% of then GDP. Right now, the American government only issues about 400 billion dollars debt each month. It will be a nightmare or it will be a nightmare? When we talk about that the math doesn't add up in the presidential debate, or when candidates were attacking each other for their elementary level math, we should know that their math both failed. No one knows the future. If the economy is going to fade even a little, the great nation will suffer a lot since the Fed is out of Ammo because liquidity was trapped and the government is trapped because of the debt ceiling. Observe closely the short term interest rate, especially the 6-month and 1-year bill rate. Increase gold in your portfolio when the short rate hits 2 percent. If it is going up 4 percent, then buy gold with all your spare money. Dollar index will drop to a historical low. A big time will come because by that time, China, Russia, Brazil, India will not be so dependent on the American market, Europe will learn from the bitter lesson from this crisis and abandon dollars. The next financial crisis is a crisis that destroys everything, provoking a war between largest nations and maybe a thorough world war. It will all happen in less than 10 years.