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I suspect that many of you are nervous with the volatility of the markets and the war in Ukraine

March 07, 2022

With the volatility of the markets and the war in Ukraine, I suspect that many of you are nervous. That is to be expected and I certainly do not have all the answers, nor does anyone. But we have history to tap to become better investors in times of turmoil and our instincts that come with 39 years managing money. I have two observations that might be helpful in understanding the problem that our government is not facing and the risk of China selling our bonds.

#1. Allow me to observe what I find curious and perplexing: According to the American Petroleum Institute, we have enough oil in North America to fuel every single passenger car and long-haul truck for the next 430 years. We have enough natural gas to provide electricity for every business and household for the next 535 years and enough coal to provide electricity for about 500 years. So, don’t you think that in 430 years we will have developed alternative fuel sources? Why then did Joe Biden sacrifice America’s energy independence, cease all exploration for oil and gas, abandon pipeline development and drive up prices of gasoline, heating oil, and jet fuel and make us once again dependent on foreign oil? And it is not just the environmentalists. 

Isn’t it curious that in some states like California, Washington, Illinois, and New York, shoplifting of items less than $950 is not a crime but, the Build Back Better Spendalooza calls for hiring 87,000 IRS agents to monitor individual banking transactions of $600 or more? So much for helping the little guy.  

Someone needs to educate me as to how we are going to produce all the batteries needed to facilitate a transition away from fossil fuels to battery-driven vehicles when the basic ingredients for batteries are all found in rare minerals such as lithium, cobalt, and zinc and others, all of which must be mined in countries not friendly to us. Also, if you have ever driven on the Cross Bronx Expressway or the 405 in Southern California and were stuck in traffic, how exactly will the repair trucks reach a disabled vehicle before their battery dies…along with the batteries of all the other vehicles in traffic?

When will construction start to build the 500,000 battery charging stations? Where will they be situated? Won’t they be powered by burning fossil fuels? 

If you ever feel like you haven’t accomplished anything, try to remember that it took 20 years, trillions of dollars, and four Presidents to replace the Taliban in Afghanistan with………. the Taliban.   

Let me try to understand this: we can’t seem to find illegals to deport, but we can sure find them to give them money! How does that work? 

If there was a barnyard election, the pigs would always vote for the person that feeds them and gives them treats, even though that same person is going to slaughter them someday. I wonder if that applies to socialism.

Memo to Generation Z and the Woke Generation: The Stars and Stripes that fly over our Nation’s Capital and are wrapped around the coffins of our honored dead who sacrificed their lives to keep us free, is my Flag. I will never apologize for it. The Flag does not stand for skin color, race, or religion. It stands for freedom.  

Does anyone else think what I just wrote is curious? And do you think that these issues can affect your money and investments? What do we do about it? 

#2. Russia's invasion of Ukraine led western nations to impose the most draconian economic sanctions in the modern era. The Russian stock and bond markets have collapsed, along with Russia's currency, the ruble.

Many investors fear that China, which has always wanted control of Taiwan, will use the mayhem of the moment to take it. Obviously, this would create even more uncertainty and mayhem, but China is more involved in global finance than Russia. The West's response to Russia has not gone unnoticed, but many fear that even if China doesn't invade, it may preemptively sell its roughly $1.1 trillion in US government debt to avoid financial retaliation. The fear is that this will cause US interest rates to soar and the US economy to suffer. 

Allow me to explain why this fear is overstated. Yes, inflation and Fed tightening are likely to push up rates in the next few years. This is what the markets should focus on, not a Chinese sell-off of US Treasury debt, which would have little impact. 

First, the total US debt is roughly $30 trillion. If China sold all its debt, it is only 3.6% of all outstanding US debt. A shock to the system maybe, on the day it happens, but just a temporary shock, not a death blow. 

Second, consider what's happened to our budget deficit in the last couple of years. Right before COVID, the Congressional Budget Office estimated that the baseline deficits for Fiscal Years 2020 and 2021, combined, would be a two-year total of $2.0 trillion. Instead, due to COVID and related shutdowns, the two-year deficit totaled $5.9 trillion. That's $3.9 trillion in extra deficits over a two-year period. And the 10-year Treasury yield is essentially where it was right before COVID hit. 

Third, the Federal Reserve shrunk its balance sheet by almost $700 billion (effectively selling debt securities) in 2018 and the first eight months of 2019. Guess what? Interest rates fell. 

Fourth, even if rates were to rise, which looks likely no matter what China does, the US economy has rarely been as insensitive to interest rates as it is today. Due to underbuilding going back a decade, there are too few homes in the US. Even if mortgage rates go up, we need more new homes. Higher interest rates might mean a greater appetite for renting versus buying, but rental units have to be built, too. Meanwhile, auto sales are very low due to supply-chain issues. As those issues gradually get resolved, auto sales should increase even if interest rates go up. (Please note that real estate is overvalued based on history despite the supply problem. I am recommending selling rentals this year.)  

Fifth, I have been predicting a round of Quantitative Tightening starting mid-year that will eventually be more aggressive than it was in 2018-19, maybe reducing the balance sheet by $100 billion per month. If am right, that would mean one year of peak QT by the Fed is even more debt being sold than all the debt China owns. And yet, the 10-year yield is still 1.8%. We know the Quantitative Tightening isn't exactly equivalent to China selling debt. But the comparison still puts the size of a potential China selloff in perspective. There has been so much new money that has been printed in the past 20 months, that taking some money off the table should have little effect.  

Sixth, it's important to remember that China didn't buy our debt as a favor to the US; they bought our debt out of self-interest. Using Treasury debt to back up their currency makes people more willing to use the renminbi. If China's government sells its Treasury debt, that appetite for the relative safety of the dollar won't disappear and citizens in China could offset this sale by buying more dollar-denominated assets.

Seventh, and most important of all, we need to recognize that interest rates are a function of economic fundamentals and expectations about the future, not who is buying and selling how much Treasury debt on any particular day. 

If China sells its Treasury debt, it's going to end up getting dollars in return. What will it do with those dollars? Swap them for a different currency...let's say Euros? Then whomever it swaps with will have the dollars. What will they do with those dollars? If China's sales of bonds drive up rates, whoever gets the dollars would likely turn around and buy US bonds. The result? No fewer dollars or bonds in the world. 

The US debt that China owns is more problematic for China than it is for the US. Moreover, if China sells US debt because it fears sanctions, then it will likely sell European debt as well. In the end, it's not the US that has a problematic conundrum.

China invading Taiwan would be a horrible event. But the fear of China hurting our economy by selling our debt is overblown.   

I hope that my thinking out loud makes you think but not worry because my point is to educate you on the truth so that you get realistic expectations and make sound decisions about your money. I am always interested in your feedback, so get back to me if you have a thought.  

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