April 13, 2009
THE NEXT HURDLE
It's hard to dismiss the ongoing news about China's anxiety over its massive holdings of American debt. What's worrisome for China is ultimately a concern for the U.S., with fallout that may come sooner than we think.
“We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried," Chinese prime minister, Wen Jiabao, said last month. It was a rare public admission of apprehension by a high-ranking Chinese official on the delicate and increasingly precarious lender-borrower relationship that describes the U.S. and China.
Today comes word that China's purchases of U.S. bonds slowed in the first two months of this year, according to new data from China's central bank, The New York Times reports. "Chinese reserves fell a record $32.6 billion in January and $1.4 billion more in February before rising $41.7 billion in March, according to figures released by the People’s Bank over the weekend," the Times notes. The trend may now be reversing, although the notion that a pivotal point in the U.S.-China financial relationship may be near remains intact.
The fear is that China will slow (cease?) buying new Treasuries, a decision that's likely to force up interest rates in the U.S. For the moment, there's no reason to dismiss that scenario, at least when it comes to the recent trend in the yield on the benchmark 10-year Treasury Note. As the chart below shows, the march upward to the 3% mark is alive and well.
What makes the rising yield in the 10-year so striking is that it comes in the wake of the Federal Reserve's announcement last month that it would directly target lowering rates on long Treasuries. The market's initial reaction was to buy Treasuries, which resulted in one of the biggest one-day drops in interest rates on record. For a time it looked like Bernanke and company had struck gold. But confidence that the central bank has complete control over the long end of the curve has been evaporating in recent weeks.
As the above chart shows, the 10-year yield collapsed by around 50 basis points on March 18, down to around 2.5%. As of April 9, the 10-year's yield had climbed by to roughly 2.9%, just under the level where when the Fed made its bombshell announcement last month.
High interest rates in the U.S. necessarily make the dollar more attractive, at least for a time. No wonder, then, that the buck's value is rising in forex markets in recent weeks, in sympathy with higher interest rates on the 10-year. The U.S. Dollar Index is just about at the highest level since the Fed's March 18 disclosure, a news event that had initially sent the buck tumbling. Meanwhile, commodity prices generally have been inching higher as well, as per the CRB Index. Commodities are generally priced in dollars, so it's no surprise that a strong dollar equates with higher commodity prices.
Higher interest rates are almost surely the path of least resistance in the years ahead, in part because the U.S. deficits are sure to be large in the wake of all the monetary and fiscal stimulus of late. The problem is that the arrival higher interest rates now, this week, next month, next quarter come at an especially inopportune time: before the economy has sufficiently recovered. The Fed surely seeks to keep long rates below 3% for the rest of the year, or so one might speculate. But it's not clear that the markets are willing to go along for the ride.
In the old days, the Fed's powers were such that it had more control over keeping interest rates low and thereby providing the economy with ample monetary stimulus until the forces of growth rose anew. Engineering that scenario this time may be tougher, much tougher. One reason is that much of the control over future rates has been transferred to foreigners, courtesy of holding large quantities of U.S. debt. That may not be fate that rates will rise. Indeed, China surely wants to keep U.S. rates low in order to boost growth here, which will promote imports of Chinese goods. But no one really knows how these forces will play out.
Perhaps the cycle will be salvaged if the economy rebounds quicker than the crowd expects. Alternatively, the Chinese and other foreigners decide to buy large quantities of Treasuries in the months and quarters ahead. There are solutions to the current dilemma, but no one should expect that they're a forgone conclusion.
Posted by jp at April 13, 2009 7:45 AM
That's true for a long-run equilibrium state, but in the short term it doesn't necessarily apply. If traders expect that the Chinese will buy fewer bonds in the future, bond prices can fall today, even though nothing's change per se other than expectations. Meanwhile, forex traders may see the resulting rise in rates as a reason to buy dollars, even though the trade may be questionable over a longer period given the economic implications.
In the long run, higher interest rates alone won't prevent a currency devaluation, so your point is well taken. But in the short run, that may not hold. The fact that Treasury yields have risen while the dollar has gained suggests as much. But given the economic backdrop, the outlook for higher yields AND a higher dollar will decouple. Not yet, though.
Posted by: JP at April 13, 2009 8:27 AM
It makes no sense to say less foreign demand for US assets is causing interest rates to go up and the resulting higher interest rates are causing more foreign demand for US assets.
If yields are going up because China is buying fewer US assets then the value of the dollar should be going down, not up.
Posted by: dk at April 13, 2009 8:09 AM