This graph underestimates the extent of the problem because the Chinese have been swapping out of their Agency securities and into Treasuries. So their *net* Agencies + Treasuries exposure is declining in ADDITION to their duration shortening exercise. I expect the yield curve to become INCREDIBLY steep in the next 2 or 3 years.
I think the next three years is going to be a wild time in the financial markets. Right now we’re in the calm before the storm. The latest 10-year budget outlook forecasts another $9 trillion in federal debt, and apparently that huge number is acceptable to the democrats. They have no plan to reduce that massive increase in debt through spending reductions or stronger economic growth. They have no intention of cutting entitlement spending, and incredibly, they even want to add on another big health care entitlement program when we can’t afford the entitlements programs we have now. It seems that some virus causing fiscal insanity has infected Washington, D.C. When I listen to democrat congressmen in their town hall meetings, they sound like car salesman or realtors who are good at dealing with people but they don’t know anything about economics. There’s a major shortage of economic knowledge in congress at this time.
At some point in a year or two, foreign governments and investors are going to lose even more confidence in the dollar and US treasury debt, if we don’t get our federal spending under control. So I’m expecting a decline in the dollar, a plunge in treasury bond prices, higher interest rates, and the spectacle of Geithner talking about his fantasies of America “living within our resource limits.” We’re heading for higher inflation for sure because the political process is broken and few candidates can campaign on responsible proposals for lower entitlement spending without being attacked by their opponent with deceptive campaign ads. There’s almost no responsible debate about entitlement spending anywhere in our political system. That only happens in the most conservative congressional districts.
After the remarkable 25-year run of strong economic growth, increasing entitlement spending, and low inflation ending in 2007, the American people believe entitlement spending can continue to grow forever without higher taxes and without a fiscal crisis, and that is a mistaken belief. Our country is older demographically than in the 90s and health care is more expensive now, so we will have to cut spending on health care (and useless federal bureaucracies) or raise taxes in the next decade either directly or through much higher inflation.