Whenever I'm asked what I think has the biggest potential impact not only on the stock market, but also on our way of life, I always point to the continued increase in government debt.
Over the short term, the Federal Reserve has attempted to stimulate the economy partially by buying U.S. Treasuries. Under normal monetary policy, the Federal Reserve only directly impacts short-term interest rates. To reduce long-term interest rates, the Fed began buying U.S. Treasuries, pushing up the price and lowering the yield.
Over the short term, we can look around today and notice that the sky is not falling. However, as government debt continues to pile on, approaching $17.0 trillion (which doesn't include unfunded liabilities), at some point, this will impact not only U.S. Treasuries, but also our entire economy.
Part of the reason that U.S. Treasuries are still in demand worldwide is that the U.S. dollar remains a reserve currency. There are benefits from a logistical standpoint in conducting business using the reserve currency to also use U.S. Treasuries for investment purposes.
However, as I've mentioned in other articles, large investors in U.S. Treasuries, such as China, are increasingly calling for a new global financial system that relies less on the U.S. dollar.
That sentiment alone should shock the politicians into action and make them realize that our biggest lenders, the ones buying our U.S. Treasuries, are questioning our ability to manage the rising pile of government debt.
The most recent data from August was that China actually reduced its holdings in U.S. Treasuries to a six-month low, according to the U.S. Department of the Treasury. (Source: "Major Foreign Holders of Treasury Securities," U.S. Department of the Treasury, October 22, 2013.)
China still remains the biggest holder of U.S. Treasuries, and our continued accumulation of government debt certainly must be a worry to not only China, but the rest of the world, as well. After all, as the reserve currency and leading economic power, how we run our economy will make an impression on the rest of the world. The way we're going now, it appears we're running our economy into the ground.
Is this reduction in U.S. Treasuries by China just a temporary blip or will foreign investors once again begin buying up our government debt going forward?
Over the short term, these types of variables are difficult to predict. As I said before, we are lucky that the rest of the world is in such a mess. However, that is no excuse for continuing to add on ever-increasing levels of government debt.
Look, we can't be hypocritical and look down our noses at nations like Greece, which also ran up its level of government debt until it was unsustainable. While we are obviously much stronger as a nation, we are nevertheless on the same path.
It is true; the budget deficit has been cut significantly. But when was the last time any politician talked about generating significant budget surpluses to actually begin paying down our government debt? It's almost as if politicians don't even know the word "surplus" exists.
One way for government debt to be reduced, other than actually paying it back, is through inflation. By creating inflation, the government debt is paid off with tomorrow's dollars, which have less buying power.
What's an investor to do?
While diversifying into other currencies would be one way to hedge, there aren't any strong alternatives at this point. I might consider the euro if the weaker nations were to leave and only strong nations like Germany remained; however, I don't see this occurring anytime soon.
The other option would be to buy assets that move up with inflation, and this certainly includes precious metals, such as gold and silver. From what I see, diversifying your portfolio into a variety of assets that include some hedge protection against inflation is a prudent course of action at this point.
This article How to Protect Your Portfolio as Government Debt Cripples America by Sasha Cekerevac, BA was originally published at Investment Contrarians