"the Fed “needs to be careful and be ready to reverse course, especially given all the money that it’s pumped into the system.”

From EconomPic Data:

"Long Bond Drops Most in 22 Years... A Trend or Volatility?

According to Brad Setser (former staff economist at the Treasury and current fellow at the Council of Foreign Relations):

In 2007, my best estimate is that China accounted for $120.3b of the $247.2b increase in the outstanding stock of marketable Treasuries not held by the Fed. China absorbed 49% of the net increase.

In 2008, my best estimate is that China bought $374.6 billion of the $1684.8 billion increase in the outstanding stock of marketable Treasuries not held by the Fed. China absorbed 22.2% of net issuance.

Thus, while China is an extremely important player in the Treasury market, purchasing 3x more Treasuries in 2008 than in 2007, they became a smaller relative player as demand from non-Chinese sources grew astronomically( THE FLIGHT TO SAFETY. WOW. ). So while there has been a media frenzy over Treasury Secretary Geithner's comments regarding Chinese currency manipulation and how China might react, it may be the lesser concern (back to Brad):

Obviously, it would be a big deal if China stopped buying and started selling. But it would be much bigger deal if private investors lost their appetite for Treasuries.

This past week we saw a massive sell off of long-dated Treasuries, supposed proof that this appetite is waning relative to the expected supply. According to Bloomberg:

Treasuries fell, with 30-year bonds losing the most this week in 22 years, as the U.S. readied $78 billion in debt sales over the next five days to finance fiscal stimulus spending projected to swell the deficit to $1 trillion.

While it is important to take note of any movement not seen in 20+ years, one week does not make a trend. In looking at the chart below, which details the historical 'week over week' change in the yield of the thirty year bond (in relative terms as a 30 bp move is obviously more drastic when yields are 2.9% vs. 10.6%), we see just how large an outlier this past week's move was (hint- the top right dot).



However, this chart also details how volatile the long bond has been... far more volatile in 2008-09 than at any other point in recent history and in both directions. The only previous time since 1980 the yield jumped or dropped at a similar magnitude was the week following Black Monday, October 1987. But that 100 bp drop (from ~10.2% to ~9.1%) was in response to a massive liquidity injection by Alan Greenspan following the 22.6% drop in the Dow on that single day.

Thus, while it is important to keep an eye on the long bond to see if the recent sell off does become a trend, please don't declare victory on your long Treasury shorts yet. Just remember, the Fed has another "weapon" available... the outright purchasing of Treasuries which may be on the way..."

From Bloomberg:

By Rich Miller

Jan. 26 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues may try once again to cure the aftermath of a bubble in one kind of asset by overheating the market for another.

Fed policy makers meeting tomorrow and the day after are exploring the purchase of longer-dated Treasury securities in an effort to push up their price and bring down their yield. Behind the potential move: a desire to reduce long-term borrowing costs at a time when the Fed can’t lower short-term interest rates any further because they are effectively at zero.

The risk is that central bankers will end up distorting the Treasury market, triggering wild swings in prices( LOOK AT THE CHART ABOVE ) -- and long-term interest rates -- as investors react to what they say and do. “It sets forth a speculative dynamic that is very unstable,” says William Poole, former president of the Federal Reserve Bank of St. Louis and now a senior fellow at the Cato Institute in Washington.

The Treasury market has “some bubble characteristics,” Bill Gross, the manager of Newport Beach, California-based Pacific Investment Management Co.’s $132 billion Total Return Fund, said in December on Bloomberg Television. He echoed that sentiment last week.

“I will say, and I have said for the past three months, the governments are very overvalued,” Gross said in a Jan. 20 interview. Treasuries last year returned 14 percent, according to Merrill Lynch & Co.’s Treasury Master Index, their best performance since 1995.

Inflated Prices

Recent history shows the economic danger of inflating asset prices. After a stock-market bubble burst in 2000, the Fed slashed interest rates to as low as 1 percent and in the process helped inflate the housing market. The collapse of that bubble is what eventually helped drive the U.S. into the current recession, the worst in a generation.

Faced with the danger of a deflationary decline in output, prices and wages, the Fed is considering steps to revive the moribund economy. On the table besides bond purchases: firming up a pledge to keep short-term interest rates low for an extended period and adopting some type of inflation target to underscore the Fed’s determination to avoid deflation.

The central bank has been buying long-term Treasury debt off and on for years as part of its day-to-day management of reserves in the banking system. Yet it has always gone out of its way to avoid influencing prices. What it’s discussing now, says former Fed Governor Laurence Meyer, is deliberately trying to push long rates below where they otherwise might be.( TRUE )

Fed Purchases

Bernanke raised this possibility in a speech on Dec. 1. While he didn’t specify what maturities the Fed might buy, in the past he has suggested that purchases might include securities with three- to six-year terms.

Investors immediately took notice, with the yield on the 10-year note falling to 2.73 percent from 2.92 percent the day before. Yields fell further on Dec. 16, dropping to 2.26 percent from 2.51 percent the previous day, after the central bank’s policy-making Federal Open Market Committee said it was studying the issue.

“Every time they mention it, the market reacts,” says Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut.

Yields have since risen, with the 10-year note ending last week at 2.62 percent. Behind the reversal: expectations of massive fresh supplies of Treasuries as the government is forced to finance an $825 billion economic-stimulus package and a possible new bank-bailout plan. This week alone, the Treasury is scheduled to auction $135 billion worth of securities.

Jump in Yields

David Rosenberg, chief North American economist for Merrill Lynch in New York, says the jump in yields may prompt the Fed to go ahead with Treasury purchases.

This isn’t the first time Bernanke and the Fed have discussed buying longer-dated securities and ended up roiling the market. Bernanke touted the idea as a tool to fight deflation in speeches in November 2002 and May 2003.

Egged on by his comments -- and later remarks by then-Fed Chairman Alan Greenspan that the central bank needed to build a “firewall” against deflation -- many investors became convinced the central bank was poised to buy bonds. The yield on the 10-year Treasury note fell to 3.11 percent in June 2003 from 3.81 percent at the start of the year.

Traders quickly reversed course as it became clear the Fed had no such intentions, sending the 10-year Treasury yield soaring to 4.6 percent just three months later, on Sept. 2.

‘Miscommunication’

Poole, who was then at the St. Louis Fed, was critical at the time of what he called the central bank’s “miscommunication.” He now sees the Fed making the same mistake with its latest suggestions that it might buy longer- dated securities.

“If they do it, it’s going to be disruptive to the market,” says Poole, who is a contributor to Bloomberg News. “If they don’t do it, it will impair the Fed’s credibility and erode the confidence the market has in the statements that the Fed makes.”

Meyer, now vice chairman of St. Louis-based Macroeconomic Advisers, says the Fed should, and probably will, go ahead with purchases as a way to lower borrowing costs. “The story is stop talking and start buying,” he says.

Still, he notes that not everyone at the Fed is enthusiastic about the idea. One concern: Foreign central banks and sovereign-wealth funds, which are big holders of Treasuries, might cool to buying many more if they believe prices are artificially high.( A GOOD POINT )

Undermine the Dollar

That may undermine the dollar. “There’s no guarantee that international investors would switch to other dollar- denominated debt if flushed from the Treasury market,” says Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, says foreign investors might also get spooked if they conclude that the Fed is monetizing the government’s debt -- in effect, printing money -- by buying Treasuries.( MAYBE )

Bernanke himself, in his 2003 speech, said monetization of the debt risked faster inflation -- something bond investors, foreign or domestic, wouldn’t like.( TRUE )

Some economists argue the Fed would help the economy more if it bought other types of debt. Even after their recent rise, 10-year Treasury yields are still well below the 4.02 percent level at the start of last year.

Corporate Bonds

Yields on investment-grade corporate bonds, in contrast, stood at 8.24 percent on Jan. 22, the latest date for which information is available, compared with 6.45 percent at the start of 2008, according to data compiled by the Fed.

Hawks at the Fed wouldn’t welcome such purchases. They are already uneasy that some of the central bank’s programs are effectively allocating credit to one part of the economy rather than others. Case in point: the Fed’s ongoing program to buy $500 billion of mortgage-backed securities, which Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has called “credit policy” rather than monetary policy.

J. Alfred Broaddus Jr., who was Richmond Fed president from 1993 to 2004, says the lesson from the early part of the decade isn’t that the Fed went too far in easing policy to avoid deflation -- it’s that policy makers should have tightened more quickly afterwards and not allowed themselves to be boxed in by their pledge to keep interest rates low for a considerable period.

In the current context, that means buying bonds “is something worth looking at,” he says. Still, the Fed “needs to be careful and be ready to reverse course, especially given all the money that it’s pumped into the system.”

To understand why China purchases US debt one has to look at the manufacturing and distribution model

A good post from The Elephant Bar:

"Why China Purchases US Debt

To understand why China purchases US debt one has to look at the manufacturing and distribution model. A totally vertically integrated company, or for that matter, a country would manufacture and sell its products directly to the consumer.

Each stage of the process would have a cost and would require a profit. A farmer would raise his own eggs and sell (trade) his surplus to his neighbor. That was how commerce began. There was no such thing as outsourcing. All costs and profits, or losses were born by the farmer. Modern society is far different.

The manufacturing and distribution process has evolved into specialists who manufacture, distribute or sell products. When China decided to get into the game of world commerce, she assessed her structural weaknesses and strengths( TRUE ). The US was a powerhouse of distribution and sales. It simply was not possible for China to set up a retail or wholesale distribution in the US which represented almost a third of global consumption.( TRUE )

Chinese strength rested in low cost manufacturing. Low cost manufacturing can be dependent on well chosen capital or intensive use of low cost labor( YES ). China used low cost labor to build capital( TRUE ).

The huge US market was open to China and welcomed low cost Chinese produced goods. US branding of products could easily allow retailers to sell American named goods produced in China.

A $90 Black and Decker appliance, made in China, could be sold for $80 to a consumer with a greater profit to the retailer than a US produced unit. China made the product and gleefully took the dollars. The Question was what to do with them?( TRUE )

The Chinese had little need for US products but a huge need for the dollars. The currency generated could be redeployed globally through banking, distribution, construction or for internal financing of capital or infrastructure. China bought US securities( BONDS ) with the trade dollars because there was nothing better or smarter for them to buy( I'M NOT SURE ABOUT THAT ). They bought a lot of securities because they had the excess cash from export.

Today China will buy US securities based upon its trade with the US. If the US slows in buying Chinese goods, China will buy fewer US securities because it has fewer dollars. If China needs more money for internal consumption, it may have to sell US securities to raise cash( TRUE ).

China will not be selling or refusing to buy US securities because they are mad at us. If China wants to sell in the US, it must take dollars and either spend them or invest them. There is no other way( TRUE ).

_______________________

U.S. Rates to Stay Low as China Cuts Debt Purchases


By Kevin Hamlin and Judy Chen

Jan. 8 (Bloomberg) -- U.S. Treasury yields are unlikely to climb significantly should a decline in China’s foreign-exchange reserves force the nation to scale back purchases of the securities, according to Fitch Ratings Ltd.

The New York Times reported yesterday that China is losing its appetite for debt from the U.S. and said this could have “painful effects for American borrowers.” Demand for Treasuries remains robust with investors shifting out of riskier assets( THE FLIGHT TO SAFETY ), and yields on 10-year bills are close to historical lows, said James McCormack, the Hong Kong-based head of Asian sovereign ratings at Fitch.

“China is going to buy less Treasuries but only because foreign exchange accumulation is not going to be so large,” he said. “It’s not as though they are shying away from Treasuries and buying something else( I AGREE ).”

China’s currency reserves, the world’s largest at about $1.9 trillion, recently fell for the first time in five years, Cai Qiusheng, who works for the State Administration of Foreign Exchange, said last month. With less dollars flowing into the country, China’s need to buy U.S. debt is reduced( TRUE ).

The total amount of U.S. government debt outstanding rose to $10.7 trillion in November, from $9.15 trillion a year earlier, as the government bailed out financial companies. President-elect Barack Obama, who takes office on Jan. 20, is pressing Congress to approve an economic stimulus plan of about $775 billion over two years.

Global Recession

“The likely scale of China’s reduced( WHICH WOULD LESSEN DEMAND AND RAISE PRICES ) purchases will not be enough to overwhelm other global factors that are pushing down rates,” said Brad Setser, a fellow at the Council on Foreign Relations in Washington.

The yield on the benchmark 10-year Treasury note was recently at 2.50 percent, compared with an average 3.64 percent last year. It reached a record low of 2.0352 percent on Dec. 18 as recessions in the U.S., Europe and Japan boosted demand for the safest assets( FLIGHT TO SAFETY ).

U.S. Deputy Secretary of State John Negroponte downplayed questions about potential conflict over how China handles its holdings of Treasuries while visiting Beijing today.

“My Chinese interlocutors pointed out that they have been very responsible in dealing with the question of the American debt that they do hold, and they want to be viewed as a reliable partner in that regard,” he told reporters at a press conference today in Beijing.( TRULY SPEAKING, THEY DO NOT WANT THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS TO END. )

Deepening Crisis

Zhu Guangyao, the Chinese Assistant Finance Minister, said on Dec. 5. that China may continue to buy U.S. Treasuries to help stabilize the American financial system as the global financial crisis deepens.( AS I SAID, THEY REALLY, REALLY, DON'T WANT THIS SYMBIOSIS TO END. )

The latest data shows China continues to have a strong appetite for U.S. debt. In September it passed Japan to become the largest overseas holder of Treasuries. China’s holdings of the securities increased $67.5 billion in October to $652.9 billion, according to Treasury Department data.

That level of purchases is probably unsustainable because China’s reserves growth has slowed, said Setser. Data on China’s foreign-exchange reserves at the end of December are scheduled for release next week.

The reserves may have declined due to “changes in valuations of assets( PRICES ), especially in euro-denominated assets,” Chinese central bank adviser Fan Gang said Jan. 6.

Euro’s Decline

The euro has fallen 18 percent against the U.S. dollar from its record high of 1.6038, touched on July 15.

China’s reserves may decline in the first half of 2009 as a pause in the yuan’s appreciation prompts speculators to pull money out of the country, Moody’s Economy.com said on Dec. 30.

Other factors that may slow growth in the reserves this year include a possible narrowing of the trade surplus( LESS MONEY FROM EXPORTS ) and less foreign direct investment.

China’s trade surplus may have dropped to $34 billion in December, from a record of $40.09 billion in the previous month, according to the median estimate in a Bloomberg survey of 17 economists.

China should diversify its currency holdings away from Treasury bills because credit default swaps show they are “a relatively big risk,” former central bank adviser Yu Yongding said Dec. 12.( THIS WAS MY EXACT POINT EARLIER. IN MY OPINION, THEY SHOULD HAVE STAYED IN AGENCIES. THEY MISREAD THE LEVEL OF GOVERNMENT GUARANTEES ON AGENCIES. )

Such diversification is not easily executed, said Stephen Green, head of China research at Standard Chartered Bank Plc in Shanghai.

“We still have the same old problem,” he said. “There are not many other places to invest the money.”( THERE ARE, BUT THEY ARE VERY CAUTIOUS. )

Posted by 2164th at 1/10/2009 06:05:00 AM