China Shuns Treasuries

This post first appeared on Minyanville.

China, now the biggest holder of US government debt, is going on a buyer's strike.

As a flight from risky financial assets pushed Treasury yields close to nil -- and as the once-red-hot Chinese economy dried up -- China's appetite for Treasuries has waned. If the trend persists, it could lead to higher borrowing costs at a time American consumers can barely afford the mountanous debt they already have.

The New York Times reports China's government is keeping more of it's vast cash reserves at home, choosing to invest in its own infrastructure rather than plow money into an investment earning them virtually nothing. Chinese banks, once encouraged to invest money abroad and actively lend to foreign borrowers, are now being urged to keep that money within their own borders.

Lower demand for US debt would lead to lower bond prices, pushing up yields. And since the Treasury market typically sets the benchmark for private borrowing, this would translate into higher rates for mortgages, credit cards and other types of consumer debt.

It's no coincidence that as Chinese appetite for American debt dried up last year, the Federal Reserve began to aggressively buy the assets China no longer wanted. Heavily invested in Treasuries, along with mortgage-backed securities issued by Fannie Mae (FNM) and Freddie Mac (FRE), China's voracious appetite for US debt is being supplanted by that of our own government.

Few experts however, expect China to abandon Treasuries altogether. Such a drastic move would effectively destroy the US economy, which would in turn be disastrous for China, not to mention the rest of the world. Still, each time the government bails out a company like General Motors (GM), Citigroup (C) or AIG (AIG) its standing with debt holders slips.

The timing couldn't be worse for the incoming administration. Promising to keep the deficit upwards of a trillion dollars for the foreseeable future, President-Elect Obama is counting on new debt issuances to finance his aggressive stimulus plan.

Without Chinese demand, Obama will be forced to rely on the Federal Reserve to be the buyer of last resort. As the Fed prints money to buy our own debt, however, each of the precious dollars Obama is pumping into the economy is worth less and less.

If this all sounds eerily familiar, it should.

A certain financial deviant, now a household name, ran a massive Ponzi scheme by repaying early investors with the money of the most recent suckers. His actual holdings were worthless - much like debt issued by a country teetering under the weight of its own massive, bloated balance sheet.

Treasuries: Not So Safe?

This post first appeared on Minyanville.

This too shall pass.

And when the financial panic abates, the safety of Treasuries will cease to be the trade du jour. Slowly, risk appetite will return - and those late pulling their money from the Treasury market could face steep losses.

The Wall Street Journal reported yesterday that, since professional money mangers can’t park their millions in wobbly US banks, they’ve flocked to the security and liquidity of the Treasury market.

Government-backed bonds, despite offering essentially no yield, have attracted billions in “smart” money in recent months. As banks failed and credit markets all but stopped functioning, the Treasury market was the only game in town. Seeking the perceived safety of the US dollar, investors drove up Treasury prices and sent their yields towards nil.

But at some point, when the willingness to take on risk returns, investors could leave the Treasury market in droves. If this were to happen, whether it be today, next week or next year, that safe trade may no longer be so safe.

In the past 2 trading days, the dollar -- for which Treasuries offer a proxy investment -- has fallen sharply, giving up recent gains. Shorts rushed to cover profitable bets on falling asset prices - and commodities responded by spiking upwards.

Respectively, gold and crude oil jumped more than 2% and 7% yesterday, while companies for which the price of “stuff” is hugely important, like US Steel (X) and Freeport McMoRan (FCX), soared.

To be sure, one day does not a trend make, and despite the longer term deflationary pressures affecting the economy, the road to lower prices won't be without its share of speed bumps. The massive amounts of liquidity injected into the financial system by the Federal Reserve and multi-billion bailouts of financial giants like Citigroup (C) and AIG (AIG) are, in the short run, inflationary.

Since the greenback is being used around the world as the equivalent of financial toilet paper, a dollar just isn’t worth what it used to be. This in turn makes imports more dear and pushes up the price of commodities, many of which are denominated in dollars.

Longer term, however, deleveraging will require the accumulation of dollars to repay debts, driving up its value. The cost of stuff, in dollar terms, will fall. And while this may sound good for a shopping trip, economists fear deflation almost as much as socializing with the opposite sex at the company Christmas party.

To find out why, just put yourself in the position of a store owner, faced with the prospect of selling everything for less. Expansion plans: Postponed. New hiring: Next year. Computer upgrades: Not a chance.

Deflation is an economy's kryptonite.