Saturday, March 24, 2012



The stock market had not a miserable week last week (the S&P was down only half a percent), but still the worst week it has had so far this calendar year. There were, as there always are when the market moves, even when it doesn’t move that much, numerous explanations for stocks’ relative difficulties, but the rationale that seemed to gain the most traction among the cognoscenti was China, which has become the all-purpose explanation for anything, financial or otherwise, over the last several years. In this instance, it is becoming clear, or about as clear as things can be in rather opaque China, that the world’s second largest economy is in the midst of a slowdown. Early in the week, in the wake of the travails of Mr. Bo Xilai, who was in charge in Chongqing (which the more seasoned of my readers will remember as Chung-king) until he, or his affinity for old-fashioned cultural revolutionary Maoism (I’d bet on the former, but that is grist for another mill.), ran afoul of party bosses in Beijing, rumors surfaced of a coup in China. If such rumors had proven to have substance, we wouldn’t be discussing a half a point drop in the S&P but, rather, would be looking to trade futures in bottled water, beef jerky, and ammunition, but I digress. When the rumors of a Chinese coup were dispelled, we were left with the fact, more or less, of a Chinese slowdown.

The reaction of the markets was pretty much as one would have expected: commodities were weak, with the exception of the late week moves in oil, which is dancing to its own dynamics, stocks were down, and bonds were up. As I was pondering the market’s actions, while cutting my lawn on Thursday for the first time this season, I came up with some fresh thinking on bonds. Hopefully, I am not just talking my position. (See my now seemingly prescient 3/10/12 post, A TRADE FOR (AT LEAST) THIS YEAR.)

Commodities fell, as they always do when it looks like China is slowing down, on projected weakness in demand. Yet, during such times, U.S. treasury bonds trade up in response to weakness in stocks that, presumably, results from fears of the ramifications of a Chinese slowdown for demand for U.S., and worldwide, exports. This conventional action in bonds might seem logical; however, why wouldn’t bonds trade down when the Chinese economy is slowing due to lack of demand, as do other commodities? If the Chinese economy is slowing, and China’s is not a conventional economy in the sense that an economic slowdown leads to declining domestic demand and hence a larger trade surplus, or smaller trade deficit, wouldn’t China generate less foreign exchange and hence less ability to purchase U.S. treasury debt? In other words, if a slow Chinese economy reduces demand for commodities like wheat, corn, oil, steel, etc., wouldn’t the same sluggishness reduce demand for treasuries?

Further, if there were, or were to be, something to the coup rumors in China, one would surely expect that U.S. treasuries would trade up on the flight to quality trade. But wouldn’t it seem logical that an overthrow of the Chinese government, and, presumably, a reordering of its export oriented economy, or even fears of such a reordering, would result in a dramatic drop in Chinese demand for treasuries and hence a blow to the solar plexus of treasury prices and the U.S. government’s ability to borrow?

Of course, those who have been paying close attention would argue that Chinese demand for treasuries has already been falling for a number of reasons. In the 12 months ended 6/30/11, increases in U.S. dollar holdings (mostly treasuries) accounted for only 15% of the total increase in Chinese reserves, down from 45% in the 12 months ended 6/30/10 and 63% in the five year period ended 6/30/11. As a result, U.S. dollar holdings comprised only 54% of Chinese reserves as of 6/30/11, down from 65% at 6/30/12. These are drastic fall-offs, and one can presume, as much as one can presume anything about Chinese finances, that the trend is continuing into 2012. But it would seem logical that a dramatic slowdown in the Chinese economy would further blunt the Chinese appetite for treasuries, albeit primarily through a decrease in overall accumulation of reserves rather than through a change in preferences regarding the composition of those reserves.

And a coup would have a much larger impact on Chinese desire to lend us money. But we don’t even want to think about that.

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