Damage Control?

So, I woke up yesterday morning mentally preparing myself to do some painful damage control. Looking at the futures market Sunday night, I saw the long bond had broken through the 50-day moving average (3.87%) sharply up to 3.91%. Since the resistance is broken, possibly ending the downtrend in yields, I thought, "have to sell here." Although I don’t like losing so much profit back to the house, I’m not going to wait and hope bonds go back. Also going to close EDZ, as emerging markets have a good deal of momentum here. I might even close SPY and try to regroup. But today’s action is decisive, so I’ll act now. Better late than never.

So, what’s changed in September? First, the equity markets were oversold, while bonds were due for a pullback. Last week was particularly frustrating for me. A steady stream of good news trickled in on marginally important data points, while on the other hand, Irish, Greek, and Spanish CDS spreads rose sharply. In addition, Japanese data was better than expected, implying reduced pressure for the Bank of Japan to weaken the Yen. I felt like a calm surface hid a strong riptide below the surface.

China
Let’s dig into some of the particular stories of interest recently. First, China. Inflation accelerated in August. The market has read this in a positive light, assuming that inflation means people are spending more and internal consumption is increasing. However, there are a couple of details that make me think differently. First, businesses have been complaining of shrinking margins, which means that inflation is not being driven by final demand, but by input prices. Some of this is rising wages, which is good for consumption. But I’m skeptical that wages are rising as fast as inflation. Second, the price increases are mostly in food. Which may not be a good thing for political stability if people get hungry. My opinion is that inflation will become a major problem soon, requiring the authorities to tighten credit. I base this conclusion on the belief that China’s economic imbalances keep getting shakier and shakier. It seems a strange portent that asset prices are falling while food prices start to take off. This bears close watching.

I also feel compelled to comment on strange logic I have heard regarding China. Some have claimed that China’s selling of Treasuries over the last year has concentrated their holdings among shorter duration bills. Since the duration is shorter, this somehow puts pressure on Treasuries as the Chinese have to explicitly act to roll over expiring bills. First of all, it’s just as easy for China to buy, sell, or roll over any maturity of Treasury bond, so this line of reasoning is just a spurious hiding of the underlying assumption that China is trying to pressure the U.S. Treasury market. However, we can see that this is not China’s intention at all when we look at the value of the Renminbi. If China wanted to pressure the dollar, they would let the Renminbi rise against it. But what has happened? A grand total of 1% appreciation. Compared to the Euro, the Yen, and the Pound, the Renminbi has fallen. The last thing China wants is a weaker U.S. dollar. But this is exactly what they get if they sell Treasuries. And the shorter the duration of the bond, the more cashlike it is. So selling short-term Treasuries is almost exactly like selling dollars, and guaranteed to push up the Rmb against the dollar.

Next, we have Australian real estate lending. The news is out that all the major banks are increasing loan to value amounts. Long term, this will increase the bust. But short-term, it may increase prices.

Basel III is a joke. Banks have eight years to double capital. Other than that, I don’t know the details. But there’s no greater sign than the market flight to risk today.

And just as I write this, I see bond yields have dropped 2 bips to 4.85 from their overnight futures high of 4.91, and the Dow Jones is up 40, down from the high of +85.

Even EEM is right at resistance levels, but no major indices have broken through.

The charts are telling me to grin and bear it, so that’s what I’ll do.