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Does a government's debt service cost matter anymore?

Economic realists wonder about what will happen to the budgets of various heavily-indebted governments when interest rates rise, and rightly so. The fact is that the debt burdens of some governments only look manageable because interest rates have been artificially reduced to ridiculously-low levels, and it seems obvious that these governments will become incapable of servicing their debts after interest rates move back to more normal levels. However, it occurs to us that a government's debt service cost doesn't matter if the central bank owns most of the debt.

The reason is that in the US and, we assume, most other countries, the central bank sends almost all of its profit to the government. This means that most of the interest paid by the government on debt held by the central bank ends up back at the government. Consequently, as far as the government's ability to fund itself is concerned, the interest rate it pays on debt held by the central bank is irrelevant. Regardless of whether it pays 0.5% interest or 10% interest, it will get back almost all of the money it pays out.

The re-cycling of the interest paid on debt held by the central bank is not something new. The significant change that has taken place over recent years is the massive increase in the amount of government debt held by the central bank. For example, over the past 7 years the Fed's holding of US Treasury securities has increased from $800B (about 8.8% of the total) to $2.5T (about 14% of the total). This effectively means that $2.5T of the US government's debt is now interest free and will remain so for as long as it is held by the Fed.

Japan provides us with an even better example. The direct debt of Japan's government is now 1.1 quadrillion Yen, which sounds like a lot of money. It is a lot of money for a country of Japan's size -- it is equivalent to about 10 trillion US dollars, or almost two-times the total amount of gold mined in the history of the world. Not only will it never be paid back, there will also never be a serious attempt to pay it back.

Somewhere in the region of 21%-24% of the Japanese government's debt is currently held by the BOJ, but the percentage is increasing rapidly because the BOJ is now buying JGBs at twice the pace at which the government is issuing them. We estimate that at its current pace of bond-buying and at the Japanese government's current pace of deficit spending, the BOJ will own half of the government's debt by 2019. This means that half of the Japanese government's debt could effectively be interest-free by 2019, regardless of what happens to interest rates. Also, since rising interest rates only affect the cost of servicing new debt, it seems to us that Japan's government will be shielded from higher interest rates for as long as the BOJ is buying more government bonds than the government is creating.

That's why an eventual rise in interest rates to more normal levels might not bring about the financial predicament for heavily-indebted governments being forecasted in some quarters.

The Stock Market

Nothing of significance happened in the US stock market over the first three days of this week. Upside momentum is waning, but there isn't yet any sign of a downward reversal.



Gold and the Dollar

Gold, Silver, and the Gold Mining Sector

The Swiss Gold Referendum

A referendum is scheduled to take place in Switzerland on 30th November that, if passed by a simple majority of voters, would require the Swiss National Bank (SNB) to hold 20% of its assets in gold. Currently, gold accounts for about 7% of the SNB's assets.

The SNB would have 5 years to bring its gold holding up to 20% of its assets. At current asset levels and prices it would need to purchase about 1500 tonnes of gold to reach the targeted level, although the amount would probably end up being greater due to additional SNB balance sheet expansion.

The SNB and Switzerland's major political parties are very much against this referendum, ostensibly because it would limit the SNB's flexibility. Limiting the SNB's flexibility would actually be a good thing, but we don't see how the 20% gold holding would establish any meaningful limits. The SNB could still increase its balance sheet as much as it wanted, it would just have to buy 20 francs of gold for every 100 francs of expansion.

Rather than the main concern being a loss of flexibility, we suspect that policy-makers are against the referendum because having a greater amount of gold on the SNB's balance sheet would put upward pressure on the franc's exchange rate. In a policy-making world dominated by Mercantilism and Keynesianism, a strong currency is anathema.

We doubt that the "yes" vote will win the day, but in any case this is not a trend-changing event in the gold market. The 300 tonnes per year that the SNB would have to buy over the next 5 years is too small, relative to the total aboveground gold supply, to have an effect beyond a very short-term, sentiment-driven reaction.

The Silver/Gold Ratio

The following weekly chart shows that a) the silver/gold ratio is not far from the major lows of 2003 and 2008, and b) the silver/gold ratio's weekly RSI is at a 15-year low. This doesn't tell us anything about silver's prospects with regard to the coming 12 months, but it means that silver is probably going to trade a long way above current levels, in dollar terms and relative to gold, within the coming three years.



Considering the performance of the silver/gold ratio and what has happened in all the financial markets, in recent years the silver/gold ratio has clearly not lived up to its reputation as an indicator of financial-market stress. It should have moved higher as financial-market stress abated and confidence rose, thus paving the way for it to reverse downward to signal the beginning of the next major shift away from risk. Instead, it did the opposite, leaving it in no position to signal a reversal of the risk trend.

Silver/gold's failure to perform as an economic confidence or financial stress indicator over the past three years is, we believe, a consequence of the extent to which silver became over-valued relative to gold during the first four months of 2011. The correction of this massive over-valuation has trumped all other considerations.

Fortunately, the GYX/gold ratio continues to do a good job of indicating the confidence trend. GYX/gold is supposed to trend in the same direction as financial-market and economic confidence, which is exactly what it has been doing.

The GYX/gold ratio should reverse course and begin trending downward as soon as the latest central-bank-sponsored boom begins to unravel.



Current Market Situation

With regard to the performances of gold bullion and the gold-mining indices over the first three days of this week, the only noteworthy development is that there was no follow-through to the upside. This is understandable in gold's case, because, as we mentioned in the Weekly Update, gold ended last week near very important resistance (refer to the first of the daily charts displayed below).

It is not surprising that gold was unable to immediately break through this resistance, but it is surprising that the HUI has been unable to build on the gains achieved during the final two days of last week. After all, the HUI fell much further than gold during the days leading up to last Thursday's reversal and remains well below its resistance equivalent to gold's $1180.

For the HUI, the first resistance of real importance lies in the 180s (refer to the second of the daily charts displayed below). IF the short-term downward trend ended last week then this resistance should be tested during the initial rally from the low, which means that it should be tested within the next several days.

We think that the HUI has a lot more upside potential than gold bullion in the short-term and the intermediate-term, but the ultra-long-term downward trend in the gold mining sector relative to gold bullion is likely to remain intact.

Over the past week, Market Vane's bullish percentage for silver hit a new 10-year low, and possibly a new all-time low, of 16%. At the other end of the sentiment spectrum is the Dollar Index, in that Market Vane's bullish percentage for the US$ just hit a new 10-year high of 84%. We know what sentiment extremes such as this lead to, but we don't know exactly when.

The Currency Market

The Dollar Index has essentially traded sideways since hitting its daily-closing high for the year last Thursday. It has therefore not yet signaled a downward reversal of its short-term trend.

The US$ continues to be supported by strength in US equities relative to European equities, with the VGK/SPY ratio, our preferred measure of European equity performance relative to US equity performance, making a new low for the year on Wednesday 12th November. As made clear by the following chart, the short-term downward trend in the euro (and, therefore, the short-term upward trend in the Dollar Index) is linked to the downward trend in the VGK/SPY ratio.



The huge speculative net-short position in euro futures is akin to potential energy. This potential energy will be converted to kinetic energy, resulting in a substantial rebound in the euro, after European equities stop weakening relative to their more expensive US counterparts.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html