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Investors digging deep will find frightening investment scenario linked to huge U.S. deficits

by Wayne Cheveldayoff, 2004-04-08

While financial markets have produced some great returns for investors over the past year, lurking beneath the surface is a frightening investment scenario linked to record-breaking U.S. deficits.

Until now, the huge U.S. government and trade deficits have not triggered higher interest rates. In fact, mortgage interest rates and bond yields remained near 50-year lows in the first quarter of 2004.

But this could easily change. The deficits have been financed mainly by Asian central banks. If this money flow is stopped for some reason, U.S. bond yields and mortgage rates could rise sharply – with negative consequences for the North American economy and stock markets.

The size of the deficits and money flows is staggering.

The U.S. federal government and current account trade deficits are each at record levels – around US$500 billion a year, or about 5 per cent of gross domestic product (GDP).

When any country has deficits of this size, foreign money to pay for them has to be attracted by either higher domestic interest rates or a decline in the country’s exchange rate (to make owning that country’s assets more attractive to foreigners).

So far, the United States has been able to avoid higher interest rates. The decline in the U.S. dollar has encouraged some inflow to finance the deficits. But the bulk of the financing has come from Japan and other Asian countries for other reasons.

In fact, Japan, working hard to avoid a rise in its own currency, has been printing yen like mad and buying U.S. dollars – to the tune of 20.4 trillion yen (US$180 billion) in 2003 and another 15.2 trillion yen (US$150 billion) in the first three months of 2004.

These U.S.-dollar purchases add to Japan’s official currency reserves (now in excess of US$550 billion) and are invested in U.S. treasury bills and bonds, thereby supplying much of the funds needed to finance the U.S. government deficit.

In fact, foreign central-bank ownership of treasuries from such foreign exchange intervention has ballooned to an enormous US$1.18 trillion recently, nearly double what it was five years ago. Overseas investors and central banks now own about 44 per cent of U.S. treasuries.

But what if this rampant foreign accumulation of U.S. debt came to a halt?

It is not a question of the current enormous holdings being sold off, which would have calamitous results.

Rather, what if the Asian and other lenders in the world simply stopped buying U.S. treasuries for a time?

With the U.S.’s hunger for financing so large, there would definitely be a sizeable impact in the markets if this happened.

The degree of impact would depend on how it happened. If it came suddenly and surprised everyone, the inescapable results would be falling U.S. treasury prices (and rising yields), a weakening U.S. dollar and stock market investors running for cover.

This would definitely put the U.S. economy at risk, since so much of the economy’s growth in the past two years has hinged on low interest rates, particularly through ballooning consumer and mortgage debt, which has fed consumer spending. Thus, any sharp rise in interest rates would undermine this source of strength and certainly slow things down generally in the economy.

However, none of this is a worry right now in the investment community. The stock and bond markets are obviously assuming that the foreign money will keep flowing and the U.S. economy will keep expanding at a fairly rapid pace.

Investors are taking the same approach to this potential problem as they are to a possible major strike by Al-Qaida on U.S. soil.

The U.S. stock market has definitely not priced in a major terror strike and therefore would be vulnerable to decline in the event of it happening.

The fact that it hasn’t been priced in despite recent warnings from the terrorists is probably because the hardest part is figuring out how and when it could happen.

The same is true in the financial arena. It’s hard to predict what could cause a curtailment in money flows from Asia or when this could happen. Or if such a development would simply cause the U.S. dollar to continue to fall without much upward pressure on U.S. interest rates.

But it seems inconceivable that the markets will continue to turn a blind eye and the United States could continue to run such mammoth deficits forever without major consequences.

If a crisis occurs, Canadian investors would not be immune. Canadian and U.S. interest rates are less linked than they once were, but the stock markets in both countries still march in tandem.

The only place investors may be able to hide is in commodities, especially gold and other precious metals, whose sharp rise in price in the past two years is in part due to worried investors seeking a ‘hard currency’ replacement for the devaluating U.S. dollar.

This is one of the reasons that some investment advisors advocate holding a portion of one’s portfolio in precious metals as insurance on the assumption that if a crisis hits, there won’t be time to take defensive action.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff