One of the most intriguing side battles being fought between China and the US over trade is what is happening with gold and US Treasury bonds.
With President Trump showing no signs of backing down from his big deficit spending ways, the US needs to attract a lot of offshore capital to buy its bonds.
China has been the biggest of those buyers but in recent times it has been selling US bonds and, instead, buying gold.
Central banks buying gold
It is not alone either, with World Gold Council figures showing that central banks in general have been buying gold – a whopping 145.5 tonnes of gold in the first quarter of this year alone.
That is certainly one of the factors that has been driving the bull market in gold.
Central banks really boosted their gold purchases last year, led by Russia and China but also by generalised buying from a range of areas including India, Asia, the Middle East and even Africa.
On one level the buying really makes sense.
US bonds still positive yield
While US Treasuries still have a positive yield – something that can’t be said for some US$12 trillion of bonds in Europe and Japan – that yield is historically small and can easily be eclipsed by even small rises in the price of gold.
Gold actually costs money to store and doesn’t yield anything, but it is worth remembering that we are a very long way from the old days of the gold standard, which allowed US citizens to exchange currency for gold – a primitive but effective form of rationing cash and containing inflation.
While famous British economist John Maynard Keynes may have described the gold standard as a “barbarous relic’’, it is interesting to imagine what he would think of the current system in which gold has been largely usurped by a deluge of Government bonds that rely on international “saving’’ nations continuing to buy the debt of “spending” nations.
Cash flows from saving countries to spending countries
Such international currency flows have always been a part of the world economy but the sheer size and volume of bond markets now is staggering.
Australia is still one of those spending nations, although by international standards we are far from the worst performer.
Our accumulated government debt should reach $629 billion this year and if you believe government forecasts – which have a habit of being wrong – we are heading for a very skinny budget surplus of $4.1 billion (0.2% of GDP) in 2019-20.
On the trade side, Australia’s exports have delivered record monthly surpluses such as February’s $4.8 billion as exports have risen and imports have been subdued.
Still, Australia’s run of budget deficits have left a government debt pile of $629 billion, which will take a long time to clear even if projected budget surpluses come to pass.
If we look at the US, which has the massive advantage of effectively running the world’s underlying currency in the form of the US dollar, we see a much more interesting picture.
The big spending and lightly taxing US Government is issuing around US$1 trillion of bonds a year, which until now has not been a problem because the US currency is so central in the world.
US bonds also have positive yields and are traded on an extraordinarily deep and liquid bond market compared to any other country.
The US federal deficit widened an incredible 77% in the first four months of fiscal 2019, up to US$310 billion from US$176 billion a year ago.
The US is also running a monthly trade deficit, which fell a little to US$51.1 billion in January 2019.
Trade deficits drive protectionist tariffs
It is these persistent trade deficits – largely with China but with many other countries as well – that has been driving President Donald Trump’s trade war actions and rhetoric.
Looking objectively as a central banker anywhere in the world, would you rather have your vault stuffed with US government bonds or would you prefer to diversify away from the US dollar through other bond purchases and also by buying gold?
Certainly, countries such as Russia have been buying gold with their ears pinned back – purchasing an amazing 274t of the soft metal last year alone.
Now the People’s Bank of China has also been buying, adding a much more modest 70t of gold since December.
At the same time, China has been selling US Bonds, cutting them from a peak of US$1.32 trillion in late 2013 to about US$1.1 trillion today.
That makes China a much smaller owner of US public debt at around 7% of the total but that is still an influential position.
Looking at the gold market, the renewed buying by central banks has the effect of soaking up a lot of the stock of gold that is being mined around the world – particularly at a time when gold mines are having to dig deeper and process more ore to produce each ounce of gold.
What if China bought gold instead of Treasuries?
If China were to start dumping US treasuries – and we are a long way away from that yet – the result could be an increase in US borrowing costs which would reduce economic growth.
It is tempting to think that the US holds all of the cards in its trade battles – that certainly seems to be the case when it takes on relative minnows such as Mexico.
However, if you run your country with trade and budget deficits and expect other countries to finance it all by selling bonds, that strategy carries risks as well as rewards.
While there are strong reasons for both China and the US to call a truce in the trade war, it would be wrong to assume that the US holds all of the cards in this battle – with major ramifications for both the price of gold and the US bond market.