Germany is taking a historic step toward issuing more debt. This is long-term bullish for Europe, and the euro, and long-term bearish for the U.S. dollar.
That, in turn, makes it a bullish development for precious metals, and base metals in general, to the extent commodities will benefit from a multi-year dollar decline.
Why would Germany’s debt issuance be bullish for Europe and bearish for the dollar?
It sounds strange, until we connect the dots between supply and demand issues and capital flows from one currency to another.
To put it simply, there is a large supply of U.S. government debt in the global financial system — more than $20 trillion worth as of this writing, with the total amount likely to increase.
At the same time, there is a far lower supply of German debt available, and an even smaller supply of ECB debt (bonds issued directly by the European Central Bank).
There are many large institutions — central banks, commercial banks, public and private pension funds, and so on — that have to hold large amounts of government debt on their books.
Government debt is seen as a safe place to “park” large amounts of capital, in the sense of just letting it sit there. These institutions have very strict rules on what they can and can’t purchase, and they typically deal with very large sums (often tens of billions, or even hundreds of billions).
Because the capital flows are so large, government debt is useful to the extent it is seen as a safe asset. These institutions need safe assets they can buy, and sit on, because there is nowhere else for the cash. (They aren’t allowed to, say, just buy gold for example. At least not yet.)
This is why trillions of dollars’ worth of sovereign debt has negative yields. The demand for the existing sovereign debt in the world is so high, these institutions are willing to take a small penalty, just to have a place to park their cash.
At the same time, Germany is seen as more fiscally responsible than the United States.
For decades Germany has booked a trade surplus, meaning the country earns more from exports than it spends on imports. Germany’s total level of borrowing is also far lower than that of the United States.
In 2020, the total amount of U.S. federal debt held by the public is close to 100% of gross domestic product (GDP), whereas Germany’s ratio of debt-to-GDP is slightly above 60%.
In plain terms, this means that, even if the German government borrowed a trillion dollars tomorrow, Germany’s debt-to-GDP ratio would still be lower than America’s.
Because Germany is so fiscally conservative — in no small part due to their Weimar hyperinflation experience nearly 100 years ago — there is a very high demand for German bunds, the German equivalent of U.S. 10-year notes and 30-year bonds.
As of this writing, the yield on the 30-year German bund is just below zero, meaning that, if the German government issued new 30-year bunds today, it could essentially borrow for free, or even get paid a small amount to borrow.
This is because bund demand is so high, institutional buyers are willing to receive nothing — or even pay a little something — to have a safe place to park their cash.
The yield on the 30-year U.S. Treasury, on the other hand, is about 1.45% as of this writing. This means buyers of U.S. Treasuries still want to get paid to lend to Uncle Sam for 30 years, albeit at a low rate.
This is understandable, too, because the expected U.S. inflation rate over 30 years is 1.71%, which means the bonds will lose money after inflation. (And could lose a lot more if inflation takes off.)
Germany is moving toward higher levels of debt issuance — a historic step — to help restart the German economy in the aftermath of the coronavirus pandemic. The German government is expected to have a 218-billion-euro budget deficit in 2020, and a deficit of 80 billion euros or more in 2021.
In some ways, Germany is too fiscally conservative. In some cases, it is possible for a country, or a company, to be borrowing less than it should. This happens when the available finance rate is low, and there are high-quality ways to invest the borrowed funds.
For example, if Germany borrowed $500 billion at a 0% rate of interest for 30 years and used the funds to repair and update crumbling infrastructure, it would have the economic benefit of better infrastructure at zero financing cost.
The reason why stepped-up German borrowing is bullish for Europe is because, as Germany starts to borrow more, capital is likely to flow out of dollar-denominated bonds and notes and into German bunds.
A big part of the reason so many central banks and institutions are heavily weighted toward dollar assets, with large amounts of U.S. government debt on the books, is simply because there isn’t a sufficient supply of high-quality alternatives.
To the extent Germany supplies more high-quality debt to the market — by borrowing more — capital will flow back toward the European debt market, and away from the U.S. market.
This will also hold true as the European Central Bank eventually starts to borrow more, through the issuance of ECB-backed bonds.
As things stand now, the various countries of the European Union are like individual U.S. states. If France wants to issue debt, it is akin to, say, Texas or New York issuing debt. The debt isn’t backed by the entire EU, in the way that U.S. Treasuries are backed by the full United States.
As the ECB starts to borrow more, however — and this will be a historic sea change, too — the bonds issued by the ECB will be seen as super-safe, on par with German bunds or U.S. Treasuries, because the full backing of the roughly $18 trillion EU economy, including Germany, will stand behind the debt.
As Germany borrows more, and the ECB borrows more too, the demand for their safe-haven debt will see capital flow out of the United States and into Europe. That will exert upward pressure on the euro and downward pressure on the dollar. In fact, we are already seeing this, which is part of the reason the euro has been strong in 2020.
Then, too, no matter how much Germany and the ECB decide to borrow, it seems clear the U.S. rate of borrowing will leave them in the dust.
Germany is a fiscally conservative country and will always remain so. Taking baby steps in the direction of budget deficits is a big deal for Germany, whereas the U.S. Congress has spent like drunken sailors for decades.
This is another reason why European-issued safe-haven assets — in the form of new debt issued by Germany and the ECB — will attract flows that come out of U.S. Treasuries.
It may sound odd to think of Europe as more fiscally prudent than the USA, but at the government-borrowing level, the evidence bears it out — largely because of Germany’s strong influence — and the USA’s willingness to borrow huge amounts is likely to accelerate in the next few years.
In a big-picture sense, all of this means capital flowing out of the United States and into Europe, which is long-term bearish for the U.S. dollar.
This is not necessarily a rejection of the dollar, however, or an elevation of the euro as superior. Instead it is more a big-picture reversion to the mean, reflecting the fact that the U.S. dollar has been overly strong, and large quantities of U.S. government debt overweighted on the world’s balance sheet, for an incredibly long time.
As that picture changes, the dollar is likely to decline — again we are describing a multi-year trend here — which in turn means assets that benefit from a weak dollar, like precious metals stocks and Bitcoin, will have a bullish tailwind for years to come.