China Losing Appetite for U.S. Debt

We had a pretty busy day in the currency markets yesterday, with the dollar rising sharply in the morning only to sell off again after lunch. The selling continued in Asian trading, and the dollar index is back down to levels it was at this time yesterday morning. These roller coaster rides will probably continue, as the markets just don’t seem to know where to take the currencies. Short-term moves will continue to be exaggerated, but the long-term dollar continues to be in place.

As I pointed out yesterday, this is a very busy week for data here in the US, and yesterday started us off with a bang. The volatile Empire manufacturing number showed a slight tick up but pretty much came in where it was expected. The more important Industrial Production and Capacity Utilization numbers followed, and both confirmed the US economy is continuing to recover…albeit at a slow pace. Industrial production increased 0.1% in February, and Capacity Utilization also increased to 72.7%. This data got the day started off right for dollar bulls, and the greenback shot up.

But in the middle of all of this economic data was a piece of information that sent a shiver through the bond markets. Global demand for US financial assets weakened in January as both China and Japan, the two biggest holders of Treasuries, reduced their positions. The Net Long-term TIC Flows were expected to come in at $47.5 billion for the month, but instead just $19.1 billion of US financial assets were purchased. Including short-term securities, total investment flows show that foreigners sold a net $33.4 billion in January after a net buying of $53.6 billion the previous month.

As readers of the Pfennig know, this is not good news for the US. We remain dependent on foreign investors, as there is just not enough ‘internal’ demand for our debt. If China and Japan continue to push away from the US debt table, interest rates in the US will rise, as we have to make the debt more attractive to pursue other buyers. China has been a net seller of US Treasuries for three straight months now, and Japan doesn’t seem to have the ability to pick up the slack. We have been warning of this for some time now, and it looks like we may be finally seeing a reduction in demand for US investments.

You would think the TIC data would have been much bigger news yesterday, but the media was busy pursuing another story regarding China. The big stories were all about how China is being pressured by the US to let the Chinese renminbi (CNY) appreciate. Chinese Premier Wen Jiabao has rebuffed these calls, saying that the renminbi is not undervalued. “We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency,” Jiabao said at a press conference yesterday. Wen’s remarks prompted traders to reduce their bets on a revaluation of the Chinese currency in the coming year. We continue to believe the Chinese will maintain a slow and steady approach to the renminbi, allowing it to appreciate just 5%-8% per year as it has done since it originally released the peg.

Chuck took a short break from baseball yesterday to send me the following from down in Jupiter FL: “More than 100 members of the US Congress on Monday called on the Obama administration to label China a currency manipulator, in a move that highlighted the pressure on Washington to take a more confrontational stance towards Beijing.

“In a letter to Treasury Secretary Timothy Geithner and Commerce Secretary Gary Locke, 130 congressmen demanded that the administration designate China a manipulator when it issues its regular report on currency manipulation next month. They called for countervailing duties to be imposed on Chinese imports.”

These lawmakers better be careful, as China continues to hold a massive amount of US debt. Who do they think will be able to purchase all of the debt we will have to issue in order to pay for all of their spending? They just don’t get it. None of them seems to be a bit worried about how we are going to be able to finance our deficits in the future. Without a cooperative China, we could see a ‘failed’ auction right here in the US, which would shake the very foundation of our financial system.

Today we will get information on the US housing market, which is still in the doldrums. Housing Starts and Building Permits are both forecast to show month on month decreases of over 3.5%. Foreclosures continue to place an abundance of home inventories on the market, pushing out new construction.

We will also get the FOMC rate decision later today. Nobody is expecting the Fed to do anything with rates, but everyone is curious to see if they signal rates could be rising sometime soon. FOMC policy makers will likely renew their pledge to keep rates low for an ‘extended period’ as US unemployment remains high and the housing market remains weak. But dollar bulls will be looking for any sign of an earlier rate increase.

Japanese policy makers will also be making a monetary policy announcement, but markets are actually expecting them to ease monetary policy even further. Economists expect the Bank of Japan policy board will increase ‘quantitative easing’ facilities, possibly doubling the inexpensive loans available to financial institutions. Japan continues to be mired in deflation, and the BOJ is doing everything they can to get their economy growing again. With rates near zero, the yen (JPY) will continue to be one of the main funding currencies of the ‘carry trade’, along with the US dollar. As the global economy recovers, investors will again look to borrow these funding currencies and invest the proceeds into higher yielding assets. We could see another round of yen weakness as these carry trades become popular again.

The euro (EUR) got some good news yesterday as the finance ministers announced they had worked out a strategy for emergency loans to Greece should they be needed. While they stopped short of setting up a ‘rescue fund’, the agreement to extend loans is pretty much exactly what Chuck thought they would agree to do. It keeps Greece from having to go to the IMF for a bailout, and should bring down Greece’s cost of funds. Technically, the finance ministers just clarified arrangements that would enable them to take coordinated action should it be necessary; so there was no ‘bailout’. This is important, as the finance ministers did not want to seem like they were opening up the vault doors, as they try to keep the rest of the PIIGS from stepping up to the feed trough.

But Greece, being Greece, asked for more. They want the Eurozone ministers to do a little more than pledge support, and have asked the Eurozone to set up a 35 billion euro combination of loans and guarantees. The Financial Times reported this morning that the Greek officials feel they need this loan facility to instill a bit of confidence in the debt markets. The Greeks will have to re-finance 10 billion euros of new bonds before the end of the month, and have a remaining 20 billion euros of debt due to be issued over the second half of this year. If they can get the Eurozone to establish this loan facility, the cost of rolling this debt will be substantially lower.

The euro also got a boost from a report that showed German consumer confidence fell. I know many of you may be re-reading that sentence, or thinking I had mistyped it; but it is correct. The euro rose after German confidence fell; the key is that the report showed confidence fell a bit less than expected. That is the game that goes on with these data releases; traders position themselves using the ‘expected’ numbers and then trade up or down depending on the actual numbers. The same thing occurs with data revisions, which can sometimes have an even larger impact than the original release.

But I digress. The ZEW German confidence report showed that German investor confidence fell less than forecast in March, and the euro rallied a bit. Many traders had taken short positions on the euro recently (talk about jumping on the bandwagon!) which places a bit of a hair trigger on the euro. Any good news for the European economy has nervous traders moving to cover these large short positions. The euro will certainly remain volatile for some time.

Gold had a big day in the overnight markets, rising almost $17 dollars to trade back above $1125 for the first time in a week. Silver also increased, rising almost 2% in the past 24 hours. Both have seen safe haven buying as the currency markets continue to be volatile, and traders wait to hear the FOMC announcement.

By Chris Gaffney

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