How to Protect Yourself – And Even Profit – if Foreign Creditors “Strike” U.S. Treasuries

By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning

The odds are good that China won’t dump its holdings of U.S. Treasuries anytime soon. But by substantially reducing its purchases of U.S. debt – or halting them completely in the form of a buyers’ strike – the Red Dragon could absolutely shatter the myth that it is the U.S. Federal Reserve that controls U.S. interest rates.

And that could also crater the bond market in the process.

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According to the U.S. Treasury Department‘s Bureau of Public Debt, the U.S. national debt stood at $ 12,684,570,896,780.80 as of March 30. That’s not a typo… we’re talking about more than $12.684 trillion – or roughly $41,200 for every man, woman and child in this country.

By the time you read this, however, that number will be even larger: That’s because the level of public debt is growing at an average of about $4.02 billion per day – and has been since September 2007.

Americans have become so used to hearing about the national debt, and so used to the huge numbers associated with it, that they’ve essentially become immune to the whole topic and just accept it as a fact of life. In doing so, unfortunately, they miss a very important point: In order for the federal government to borrow this money, someone has to be willing to lend it.

This really hasn’t been an issue in years past because our government has financed the bulk of our national debt by regularly auctioning new Treasury securities of varying maturities ­- from as little as 90 days to as much as 30 years, generally speaking – to the public, which includes institutions such as banks and mutual-fund companies, private investors and, most notably, foreign governments and central banks.

As of the end of March, Treasury securities buyers held almost two-thirds of the total U.S. national debt, or roughly $8.2 trillion. That equates to about 56% of the U.S. economy’s annual output, as measured by gross domestic product (GDP). The remainder of the national debt – about $4.48 trillion – is money the government owes itself as part of reserve funds for various programs, such as Social Security.

Although the massive national debt is troublesome, as is the continued deficit spending, we could probably live with this situation, assuming the economy continues its recovery. After all, government debt has been a major feature of American life for decades, now.

Unfortunately, the federal government keeps creating new debt, and trying to sell more Treasury securities to finance it, meaning the demand for those securities is falling sharply.

And by all indications, this decline in demand could get worse.

In fact, if you look at recent Treasury sales numbers, it appears that international buyers – led by China and Japan – are drastically reducing their purchases of long-term U.S. bonds, notes and stocks.

According to recently released data, foreign purchases of U.S. Treasury securities declined to a net total (total purchases minus total sales) of just $19.1 billion in January, down 69.8% from $63.3 billion worth of net purchases in December.

China accounted for a huge chunk of that drop, selling $5.8 billion more in U.S. debt securities than it purchased, which reduced Beijing’s total holdings of U.S. government paper to just under $890 billion. This was the third straight month in which China was a net seller of U.S. debt, extending a downward trend that stretches back to July 2009, when China held almost $940 billion in U.S. Treasuries.

Japan, the second-largest foreign holder of U.S. debt, was also a net seller in January, with Tokyo’s holdings falling to $765.4 billion, a decline of $300 million from the month before.

It’s been more than a year since I first warned that this storm was brewing. Foreign governments were growing disenchanted with Washington’s inability to keep its financial house in order, particularly since that escalated concerns about the safety of the U.S. dollar. On top of that, overseas central banks are exceptionally concerned about the U.S. Fed’s insistence on maintaining artificially low interest rates – a more-recent development that’s nevertheless exacerbating fears about the health of the U.S. greenback.

Those fears are finally coming to a head. Now, barring some quick policy actions in Washington, our foreign creditors may well take matters into their own hands – possibly even staging a “buyers’ strike” against new U.S. Treasury offerings – ostensibly in an effort to force the Fed to raise U.S. interest rates.

In what would stand as a dramatic example of the classic supply/demand equation, the sharp drop in foreign demand for U.S. government debt in the face of the inevitable steady increase in supply could cause bond prices to plummet.

Couple that with the inverse relationship in the pricing of Treasury securities, and we would see bond yields zoom in order to attract sufficient buyers. Millions of investors would get crushed.

Historically, China has moved with practiced caution in this area. But as the fallout from the global financial crisis continues to play out, my sense is that as China’s domestic markets gain power (and exports become less important) Beijing could react both quickly and decisively if it feels threatened, or even just insulted, as was clearly demonstrated in the recent showdown with Google Inc. (Nasdaq: GOOG).

Unfortunately, at least where China is concerned, there seems to be something of an ill wind blowing in Washington, with gusts that at times appear both threatening and insulting.

For some time now, the United States has been trying to get China to let its currency, the yuan, appreciate against the dollar, a move that would help stem a growing upward trend in the U.S. current accounts deficit – in simple terms, the amount by which the wealth (in all forms) that’s flowing out of this country exceeds the wealth that’s coming in.

For the last two years, China, in order to support its own balance of trade, has resisted holding the yuan steady against the dollar. By devaluing the yuan, China makes its exports seem cheaper to foreign consumers, which generates larger trade surpluses and brings in more cash to bolster the $2.4 trillion in foreign reserves the country already holds. China accounts for 31% of the world’s foreign reserves, according to recent published reports.

As a result, Washington will decide later this month whether to declare China a ” currency manipulator” – a seldom-used designation that would allow the United States to impose a variety of trade restrictions, including new tariffs, import quotas and the like. In my opinion – shared by many others who closely follow China-U.S. relations – that would undoubtedly provoke a trade war, in which both sides would ultimately lose.

More potentially damaging, however, would be a decision in anger by China to retaliate by completely halting new purchases of U.S. Treasury securities – a move that would severely hamper Washington’s ability to borrow money to fund ongoing government operations and future deficits. This year alone, Washington will need to issue a record $1.6 trillion in new debt just to fund the shortfall between tax receipts and projected spending.

Indeed, it’s highly likely that the big cutback in China’s U.S. Treasury purchases we’ve seen during the past three months is meant as a warning of Beijing’s willingness to play hardball. It’s also a sign of China’s growing unhappiness with Washington’s spendthrift ways and the way in which the U.S. government has undermined the value of its own currency.

It’s a warning Washington would be ill advised to ignore.

The United States would be better served to allow interest rates to rise to realistic levels, while also shifting the domestic focus from artificial “stimulus” to reduction of the federal deficit. Such a strategy would undoubtedly cause significant near-term pain. But it would put the U.S. economy on course for sustained, healthy growth, while simultaneously bolstering the nation’s relationship with its foreign creditors.

If you see a similar scenario as inevitable, consider investments such as the ProFunds Rising Rates Opportunity Investment Fund (RRPIX), which is positioned to post substantial gains as interest rates rise.

You could also consider creating a hedging program of your own, using such exchange-traded-fund (ETF) investments as the SPDR Gold Trust (NYSE: GLD), or the United States Oil Fund LP (NYSE: USO). Those two ETFs closely track the world’s two most actively traded “currency alternatives” – gold and oil.

Many governments around the world see this same trend unfolding. Those nations have already started establishing non-currency “reserves” as a hedge against this contingency, and are making serious investments in gold, oil, minerals and other commodities. With the long-term economic growth projected for China, India and other emerging economies, commodity prices are destined to rise in price anyway, which makes those commodities a sound investment, as well as a viable hedge.

It’s a trend that U.S. investors would do well to note.

[Editor’s Note: Money Morning Chief Investment Strategist Keith Fitz-Gerald is a perfect 22 for 22 with the recommendations made for his Geiger Index advisory service. It’s a stunning record, but to those who know Fitz-Gerald well, it’s actually not a surprise. A veteran trader, skilled analyst and noted market tactician, Fitz-Gerald is known for being able to see through the confusing haze of today’s quickly changing markets to visualize and understand what the future really holds. This ability to predict looming changes is a key reason Fitz-Gerald is also able to divine the profit opportunities those changes will create. It’s also a big reason he’s been able to maintain a perfect track record with The Geiger Index. If you would like more information about the Geiger service, please click here.]

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