The further a society drifts from the truth, the more it will hate those who speak it. ... In a time of deceit, telling the truth is a revolutionary act. George Orwell

Wednesday, March 18, 2009

US TBonds crashing?

What makes me think of that possibility?

Fekete's article:

... U.S. debt [1T$ in TBonds] in Chinese hands has no definable value: any time the Chinese want to sell a sizeable amount, all bids are withdrawn. The Chinese are stuck with it. They have to wait for their money until maturity. But who knows what the purchasing power of the dollar will then be? The best the Chinese can do is to “grin and bear it.” They can’t even say “ouch”, because this would further hasten the deterioration of marketability of their paper. The periodic warnings from China that the U.S. government should display greater fiscal responsibility and it should follow a stricter monetary regimen sound like whistling in the dark. ...

And this:

Fed to buy up to $300B long-term Treasury bonds

WASHINGTON (AP) -- The Federal Reserve announced Wednesday it will spend up to $300 billion over the next six months to buy long-term government bonds, a new step aimed at lifting the country out of recession by lowering rates on mortgages and other consumer debt. ...

Let me review some of the relevant events of the last months, chronologically:

1) Chinese gov is declaring a 600B$ stimulus for Chinese infrastructure

2) Chinese central bank is (probably) trying to sell some of their US TBonds discovering (probably) that they either cannot sell or that they have to discount them.

3) Chinese government officials complain to the US government and criticize US in public on the subject of the integrity of the foreign held paper assets issued by the US Treasury.

4) For the first time since the financial crisis begun, Federal Reserve is printing very large amount of cash (300B$) to buy TBonds on the market.

Why do I have a nagging suspicion that the events 2 and 4 may be somehow related? Is the Federal Reserve buying up the US TBonds that the Chinese bank was trying to sell on the market but couldn't? Note that buying TBond by Fed is equivalent of printing cash! 300B$ is probably 20-30% of the existing money (M1) in circulation.


- this is highly inflationary, and is likely to counteract the current bank-bailout engineered deflationary credit squeeze.

- the old rule that the pre-mature resale value of the long bonds (but not short term bills) is supposed to be inversely proportional to the yield, no longer seems to apply or requires a large correction factor in the zero yield limit.

I suspect that the long term fixed income assets become illiquid or may even lose value once the yield goes below about 3% or so (at present). It's a case of a theory stretched and extrapolated beyond it's proven domain. Everyone assumed that since lowering the yields from 12% to 6% increased the money velocity in the past and increased credit supply, then lowering it from 3% down to 1.5% or from 0.5% to 0.25% is going to have a similar effect. I think what the present events have demonstrated is that the system is non-linear and that the money supply versus yield curve reverses below a certain yield threshold such as 6% (not sure of the exact figure, read also this - scroll down to the entry on Wed 2 July 2003 titled "What exactly is the relation between interest rates and inflation?" ). The result seems to be the opposite to the expected: forcing the Treasury yields below 3% seemed to have REDUCED the credit supply on the market and led to deflation!

Since everybody loves predictions, I have to finish on this note:

- if China could not easely sell their TBonds so will the US gov not be able to do so either, in the nearest future, forcing the US gov to print even more money than today's 300B$, counteracting deflation and eventually (probably) causing inflation.

- falling TBond resale prices on the open market will increase inflationary expectations and will force all the other new bonds to carry higher yields - despite the government's central banks declarations.

- large players, such as sovereign funds are likely to question the role of the dollar as the universal currency, to renumerate their assets in. The death of the US TBonds (if that happens) means also a death of the dollar!

P.S. (21/03)

I wrote it in the morning, later it was announced that the total sum is 1.2T$: 300B$ of new cash to buy US TBonds on the market and the rest to buy some other dodgy paper assets. That move is effectively doubling the money supply. I have seen that kind of economics in the People's Republic of Poland in the 1970-ties. I have seen the "future" and it did not work! Ask any Pole who lived through this period what a "virtual coal" was. 8-)


JC said...

The Chinese would not hold as much US debt had they not manipulated their currency exchange rate.They have themselves to blame.

Stan (Heretic) said...

True but the whole imbalance begun years ago when the US government, the custodian of the world currency begun manipulating the interest rate, first above and then below the level that allowed rational credit allocation. Since 1996, the interest rates and credit became to ubiquitous (too cheap) leading to over-investment in the high tech industries at first then in property sector which caused more bubbles.

Over-investment has quickly eroded the profit margins which then forced the industry off-shore to cheap labor countries to restore the margins.

The erosion of the profit margins over all sectors, has also lead the banks to increase the leverage beyond belief, in order to maintain the profitability.

That is I think the primary cause of the China boom.

Off-shoring the industrial investment did not cure the primary disease that is the over-investment due to cheap credit due to interest rates held too low for too long; it only shifted that over-investment from one place (USA) to another (China).

The over-investment has in turn led to excessive debt crisis that we are now experiencing.

It's all US government's fault and their banking buddies with their flawed belief that the interest rates can and _should_ be manipulated at will.

Stan (Heretic)