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.

Can China Crash the US Treasury Market?

Recently, there has been much vocalizing by bond bears in regards to a "Treasury Bubble." These bears point to the enormous U.S. budget deficit, expected to reach $1.47 trillion this year. This increase in supply would normally be expected to exert downward price pressure. On the demand side, they point at China and ask what happens if Chinese demand for Treasuries drops?

This question may have just been answered. ZeroHedge has just analyzed data showing that China's Treasury holdings are down by $100 billion in the last twelve months. This must come as a serious surprise to the myriad of Bond Bears who believe in a "Treasury Bubble."

China has been very busy buying Yen and Euros instead of dollars this year. And guess what? It hasn’t hurt the Treasury market one iota. Instead, the Yen is at a 15 year high against the dollar. The euro has climbed from $1.20 to $1.30. And surprise, surprise, the Yuan has fallen 1.8% against the dollar in the last five trading days.


China can’t sell big chunks of Treasuries for many reasons. First, the political backlash would be huge if they drove prices down and took losses. Second, what would they buy instead? Buying commodities will increase the inflation that’s already picking up in China. You yourself posted about how increases in raw materials is a death-blow for low margin exporters. What else can they buy? They’re already buying Yen and Euros. If this is increased, Europe has no qualms about protectionism. Japan will just print, knowing that inflation will hurt China more.

The simple fact is that China is not buying Treasuries because it's getting more bang for the buck by buying the Yen and the euro. The data from the past year should convince the bond bears that they need to find more arguments besides "China might sell Treasuries."
Finally, I would like to thank two sources authoritative sources I am indebted to. Michael Pettis provides the best analysis of China in a global context that I have seen. His analysis of the structure of China's economy and what the People's Bank of China can and cannot do is spot on. Dave Rosenberg is the best US economist I know.