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FRED
06-13-07, 06:50 PM
http://www.itulip.com/images/EJvineyardHS.jpgGreenspan's Conundrum is now Bernanke's Un-Conundrum, to the Fed's Surprise - Part I

Recent bond yield increases didn't only surprise the markets. They surprised the Fed, too. Why? What are these guys smoking?

Remember Greenspan's famous "Conundrum" speech? In semiannual testimony of the Monetary Policy Report to the Congress (http://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm) before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 16, 2005, he said:

There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.
Not so short term, as it turned out. September 14, 2006, The Economist explained in Unnatural causes of debt (http://www.economist.com/surveys/displaystory.cfm?story_id=7878038)

Analysts have put forward two main explanations for the low level of real bond yields in recent years. The first is that high saving (in relation to investment) by Asian economies and Middle East oil exporters has caused a global saving glut, pushing down yields. These economies are running large current-account surpluses, and much of that money has been piled up in official reserves, particularly in American Treasury securities, as central banks have intervened in the foreign-exchange market to prevent their currencies from rising.

Of gluts and floods

Various estimates suggest that such foreign-exchange intervention reduced American yields by less than one percentage point in 2004-05. But Nouriel Roubini and Brad Setser of Roubini Global Economics reckon that the impact could be larger. Most studies ignore the fact that without official intervention by foreign central banks the dollar would be lower and hence American inflation higher, which would push bond yields higher. And if central banks were not buying dollars to prop up the currency, many private investors might hold fewer greenbacks, which again would push up yields. Adding up these and other factors, Messrs Roubini and Setser reckon that American Treasury bond yields would have been two percentage points higher in recent years if central banks in emerging economies had not bought dollar reserve assets.

A second explanation for low bond yields is that excess liquidity has pushed up the prices of all assets, including bonds. Over the past few years, the global money supply has grown at its fastest pace since the 1980s. This excess liquidity has not pushed up conventional inflation (thanks largely to cheap Chinese goods), but has fed into a series of asset-price bubbles around the world.

Both developed and emerging economies have contributed to this flood of liquidity. Central banks in rich countries have held interest rates abnormally low to offset disinflationary pressures from emerging economies. At the same time, to prevent their currencies rising, emerging economies have also held interest rates low and engaged in heavy foreign-exchange intervention, which has inflated their money supplies.

Both of these explanations for low interest rates—the saving glut and the excess liquidity—involve emerging economies; either through their impact on developed economies' inflation and hence monetary policy, or through their foreign-exchange intervention. In that sense, global monetary conditions are increasingly being influenced by policies in Beijing as much as in Washington, DC. Over the past year, emerging economies have accounted for four-fifths of the growth in the world's monetary base.
We have since April 2006 posited that China is in a better position to do without the U.S. as a source of export demand than the U.S. is in a position to do without China as a source of demand for dollar denominated financial assets.

In Economic M.A.D. (http://www.itulip.com/economicMAD.htm) we said:

Easy to confuse the commitment of one nation to another for an act of friendship. As mid-19th century British Prime Minister Lord Palmerston once commented, nations don’t have friends; nations have interests. The mutual interests of China and the U.S. are the kind that kept the U.S. and the Soviet Union from going at each other with nukes during the Cold War.

China and the U.S. are running inter-dependent bubble economies, relying on the economic equivalent of Mutually Assured Destruction (M.A.D.) to keep one from blowing up the other’s economy. Whether by intent or accident, sooner or later market forces will assert themselves and both economies will go through tough transitions. How will the world look after that?
Our expectation was that in time the U.S. would experience a housing bubble bust driven recession about two years after the start of a ten year decline in housing prices, which began mind-2005. Well before consumption of Chinese exports actually declined, China would step up exports to other Asian and European markets. Then, likely a few months before the recession, China would begin to reduce purchases of U.S. financial assets, especially treasuries. The long term result of the unwinding of the conundrum is a persistent U.S. stagflation.

iTulip's John Serrapere spells it out in detail in his series Stagflation Trade (http://www.itulip.com/forums/showthread.php?t=1081).

Last week, the leading edge of the recession arrived in the form of a rapid rise in bond yields. This came as a surprise to the Fed, apparently. The followed was extracted from the June 2007 Livingston Survey (PDF) (http://www.phil.frb.org/files/liv/livjun07.pdf).

What is The Livingston Survey?

The Livingston Survey was started in 1946 by the late columnist Joseph Livingston. It is the oldest continuous survey of economists' expectations. It summarizes the forecasts of economists from industry, government, banking, and academia. The Federal Reserve Bank of Philadelphia took responsibility for the survey in 1990.

The Livingston Survey's data base offers the actual releases, documentation, mean and median data of all the respondents as well as the individual responses from each economist. The individual responses, which are kept confidential by using identification numbers, are in a separate file, organized by variable.
Here's what the recent June 2007 report projected.

Interest Rates Will Increase Slightly in the Near Term

Interest rates on three-month Treasury bills will essentially remain steady over the next year and a half, rising slightly by the end of 2008, according to the forecasters. They expect the interest rate to be 4.90 percent in June 2007, 4.93 percent in December 2007, and 4.92 percent in June 2008. They predict the rate will increase to 4.95 percent by December 2008. Long-term interest rates are expected to rise over the next year and a half. The interest rate on 10-year Treasury bonds is projected to be 4.78 percent by the end of June 2007 and then to rise to 4.95 percent by December 2007. In 2008, a more gradual increase is expected: the forecasters predict that the rate will be 5.00 percent by June 2008 and that it will inch up to 5.05 percent by December 2008. The current forecasts are slightly lower, on average, than the December 2006 forecasts.


http://www.itulip.com/images/FedProjections.gif

As readers know, 10-year Treasury bonds are already above 5.20. Doesn't exactly inspire confidence, does it? The folks over at Lombard Street Research seem to have a better handle on the situation.

China breaks up with the US (http://ftalphaville.ft.com/blog/2007/06/12/5144/lombard-street-research-china-breaks-up-with-the-us/)

The Sino-US marriage of convenience is breaking up as the US households’ willingness to borrow and spend gets exhausted. Falling US real imports reveal weak domestic demand. Asian exports to the US are faltering. Chinese exports to the US are holding up, but not for long. China’s new object of desire – thriving Europe – adds an acrimonious twist by allowing the yuan/dollar rate to rise. Last week’s US bond market sell-off was the result, likely to further depress the economy.

China and the US have enjoyed a long marriage of convenience. Actually, China moved in uninvited. But as it put its huge savings on the table, America found it too rude to refuse. Both economies have enjoyed the good times as China’s excess savings found an outlet to induce the extra US spending the Communist state needed to keep its economy growing fast. The world as a whole enjoyed Goldilocks: low interest rates, low inflation, rising asset prices and a booming economy. As long as liquidity was sloshing around, providing the collateral for the build-up of domestic debt, the US consumer could enjoy spending beyond their means. But overinvestment in the housing market has put a spanner in the works. House prices are no longer rising; household assets are no longer rising; the borrowing and spending spree is over.

US April trade data, out last Friday, showed real non-oil goods imports down in April on the first quarter, suggesting consumer spending is faltering. Strong survey data may have prompted analysts to expect a rebound, but the real data are pointing to continued weakness. The US import downswing has been reflected in falling Asian exports. Exports to the US from Malaysia, Thailand and Singapore have all been declining since the end of last year. Today’s May trade data from China shows that exports to the US have held up well, growing by 16% in the year, although down from the 21% in Q1.

So far in the second quarter Chinese total exports have expanded at a fast pace. At 27%, although down from 29% in Q2, annual growth remains strong. China’s current account surplus continues to swell, with no respite in sight. The revival of Euroland, de-coupling from the US for the time being, has helped Chinese exports forge ahead. It has also allowed the Chinese to let the yuan appreciate vis--vis the dollar. No wonder that the US bond market sold off last week as it is no longer the default investment destination for China, or the rest of Asia for that matter. China’s new object of desire has turned its breakup with the US into an even more acrimonious one. Higher bond yields are not what the US needs now, even though some in the Fed might think so. The US has a stagflation problem, not an inflation one.
Greenspan's "conundrum" is running in reverse. If the dynamic of the conundrum was to hold interest rates lower than otherwise expected during a period of strong economic growth in the U.S., no one should be surprised that as the process reverses the U.S. is due to experience high interest rates during a period of low growth and recession as foreign demand for US treasuries declines (http://www.itulip.com/stagflationgodzilla.htm).

Continued on iTulip Select: Greenspan's Conundrum is now Bernanke's Un-Conundrum, to the Fed's Surprise - Part II (http://www.itulip.com/forums/showthread.php?t=1464)

iTulip Select: The Investment Thesis for the Next Cycle (http://www.itulip.com/forums/showthread.php?t=1032).
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JayDee
06-13-07, 08:04 PM
Where's your evidence that this is a surprise to the Fed? I don't think one can dismiss the possibility that the rise in long rates was engineered by the Fed (in concert with other central banks) as a response to the undesirable M&A/Private Equity/Going Private/Corporate Releveraging mania. If so, I applaud them.

Also, if the Chinese stop buying U.S. Treasuries and Agencies and start buying Peruvian copper mines and Canadian oil sands, it doesn't rid the world of the surplus dollar problem, it instead litterally becomes a game of Pass the Buck. In such a case the Peruvians and Canadians will have to recycle into U.S. assets instead of the Chinese. Six of one, half dozen of the other.

jk
06-13-07, 08:55 PM
Also, if the Chinese stop buying U.S. Treasuries and Agencies and start buying Peruvian copper mines and Canadian oil sands, it doesn't rid the world of the surplus dollar problem, it instead litterally becomes a game of Pass the Buck. In such a case the Peruvians and Canadians will have to recycle into U.S. assets instead of the Chinese. Six of one, half dozen of the other.
if u.s. consumption slows, so will u.s. imports, and so will the flow of [new] dollars abroad to be recycled. unfortunately, our deficits will still need to be funded. by whom?

bart
06-15-07, 12:54 PM
From the unconventional side, I believe that the recent interest rate move was not at all a surprise to the Fed but rather yet another condition when they say one thing and do another.

In the esoteric area of Fed Open Market Operations (things the Fed does to theoretically aid the economy, smooth and control money supply, etc.), there's something called Securities Lending.
To cut to the chase, changes in what the Fed is doing with SecLend are very highly correlated with what happens with interest rates. Note that SecLend operations involve billions and sometimes tens of billions of dollars per day.

The chart below shows two SecLend rates of change along with the 10 year T-Bond. With one exception in 2005, when the green line goes up (frequently it's preceded by the blue line which is just a shorter term moving average), rates go up too. I believe that this is proof that the Fed was very much not surprised at the move, but rather strongly helped to create it... and is continuing to try and push rates up.


http://www.nowandfutures.com/images/fed_seclend_bond.png

jk
06-15-07, 08:19 PM
http://www.bloomberg.com/apps/news?pid=20601087&sid=a8d6Q0WbFht8&refer=home

China Sells Treasuries, Signaling Diversification

By Kevin Carmichael and Ye Xie


June 15 (Bloomberg) -- Chinese investors sold more U.S. Treasury securities in April than any time in at least seven years, a signal the nation may be diversifying the world's largest foreign-exchange reserves.
China, which owns more U.S. debt than any foreign nation except Japan, sold a net $5.8 billion of Treasuries, the first drop in holdings since October 2005, according to Treasury Department figures that go back to 2000. The nation held $414 billion of the $4.4 trillion of marketable Treasuries in April, according to today's report.
China, whose reserves reached $1.2 trillion in March, and other Asian and oil-exporting nations are seeking to lift returns on their investments. That may push up yields on Treasuries, traditionally among the top investments for reserves, and erode demand for the dollar.
``It's part of the ongoing, gradual, long-term diversification story,'' said Samarjit Shankar, director of global strategy for the foreign-exchange group in Boston at Mellon Financial Corp. ``It may not necessarily impact the daily market, but this does raise the concern about the dollar.''
China's government announced in March it would establish an agency modeled on Singapore's Temasek Holdings Pte to manage part of its foreign-exchange reserves. Analysts estimate the State Investment Co. may start with $200 billion in capital.
``The old saying was `China would buy Treasuries come hell or high water,''' said Michael Gregory, a senior economist who covers the U.S. economy for BMO Nesbitt Burns in Toronto. ``The move to more active reserve management is going to spell trouble for Treasuries.''
Foreign Holdings
Foreign investors own about half of all marketable Treasuries. The Treasury Department's monthly international capital report today showed investors abroad bought a net $376 million of U.S. government debt in April, the smallest amount in a year. The U.K., which, through London, acts as a transit point for international investors, sold a net $12.4 billion.
Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York, cautioned against conclusions based on one month, as the figures are regularly revised.
``There's no clear sign they are going dump Treasuries,'' said Chandler, noting that Chinese officials have said they have no intention of doing anything that would devalue their holdings.
Greg Anderson, director of currency strategy at ABN Amro Bank NV in Chicago, said he was unconcerned about the decline in China's holdings of Treasuries because the country is still buying U.S. assets, providing support for the dollar.

bart
06-15-07, 08:37 PM
Chinese investors sold more U.S. Treasury securities in April than any time in at least seven years, a signal the nation may be diversifying the world's largest foreign-exchange reserves.

While that is true, it's also only part of the picture.

The actual total flow from China to the US per the Treasury (TIC) report (http://www.ustreas.gov/tic/s1_41408.txt) was over +$12 billion. The full report includes flows to and from Gov't Agency securities and stocks and bonds, as well as Treasuries.

In my opinion, there's a political element to the Bloomberg piece.

jk
06-15-07, 08:42 PM
While that is true, it's also only part of the picture.

The actual total flow from China to the US per the Treasury (TIC) report (http://www.ustreas.gov/tic/s1_41408.txt) was over +$12 billion. The full report includes flows to and from Gov't Agency securities and stocks and bonds, as well as Treasuries.

In my opinion, there's a political element to the Bloomberg piece.

even if the chinese were in fact buying, net, u.s. assets, they clearly shifted the asset mix. that, i thought, was the point in saying they were diversifying. i think if they, e.g., were buying equities, corporates or even agencies that represents a shift in the mix with implications for interest rates and asset prices.

bart
06-15-07, 08:45 PM
even if the chinese were in fact buying, net, u.s. assets, they clearly shifted the asset mix. that, i thought, was the point in saying they were diversifying. i think if they, e.g., were buying equities, corporates or even agencies that represents a shift in the mix with implications for interest rates and asset prices.

Very true and that was part of the last sentence or two in the article, but it was factually incomplete.

I just wanted to make sure that no one got the wrong idea about the total flows from China to the US.

jk
06-16-07, 07:21 AM
from john mauldin's excellent piece this weekend:

http://2000wave.com/article.asp?id=mwo061507




If they are not pegging the dollar that would allow the Chinese to shift their reserves assets into currencies that they KNOW are going to outperform the dollar because of their own actions. It is clear that part of the conundrum of lower long term interest rates is in part answered by massive foreign central bank investment into dollars. If that starts to go away, you will also see the conundrum of lower rates go away as well.


And that policy may in fact be happening as I write. Greg Weldon, on of my favorite purveyors of all things financial, offers us some interesting insight into the Treasury International Capital (TIC) data released Friday morning. He looked into some of the details that have to raise some eyebrows this weekend. It explains why stocks and US equities are soaring and US Treasury bonds are under such severe pressure. Let's look at the TIC data from Greg (www.weldononline.com (http://www.weldononline.com/))


"*Total Net Foreign Purchases of Agencies ... $36.12 billion, more than double March's $15.14 billion, and FAR MORE than $2.43 bln in Feb.


"*Total Net Foreign Purchases of Equities ... $27.42 billion, more than three times the March total of $8.77 billion, and more than twice February's $12.39 billion.


"*Total Net Foreign Purchases of Corporate Bonds ... $33.53 billion, and while less than in March of February, the three-month cumulative total is a mind-blowing $124.24 billion.


"Between Agencies, Corporate Bonds, and Equities, foreigners made net cumulative purchases of $97.07 billion during the month of April. With that figure in mind, nearly $100 billion, we note:


"Total Net Foreign Purchases of US Treasuries ... $ 0.376 billion Yes, less than $400 million, or, less than HALF A BILLION. Out of $97.4 billion in "Net Domestic Securities Purchased", US Treasury paper constituted ONLY four-tenths of one percent of the total.


"There is NO fear. There is only excess USD liquidity that is flowing into everything EXCEPT the "low risk, flight-to-safety' sector ... the US Treasury market. Moreover, "Official Foreign Institutions" (ie: global central banks) were net BUYERS ... meaning ... private foreign institutions and investors were actually DUMPING US BONDS, and reallocating more heavily into equity purchases."


There is no reason to think this has stopped. It is driving the markets, raising both stocks and interest rates. And then Greg brings us to the point that is germane to our discussion on China. I haven't seen anyone else note this, which is one of the reasons Greg is a must read for me. He finds these details.


"MORE problematic ... and something NO ONE seems to be talking about, China REDUCED their holdings of US Treasuries. Again ... the Chinese Central

Bank DUMPED US Bonds in April. Note:


"Chinese Holdings of US Treasury Bonds ... $414.0 billion, DOWN (-) $5.9 billion in the month, falling from $419.8 billion.


"Again, we magnify the point ... China sold 1.5% of their UST holdings. Bottom Line: the management of Chinese USD reserves (not to mention Korea, an active 're-allocator"), are helping reflate asset markets, and helping push US bond yields higher."


Hmm. The Chinese sell $6 billion in Treasuries and spend $3 billion to buy 10% of Blackstone. Kind of makes you wonder where the value is? Would I rather have a dollar in Blackstone (at Pre-IPO prices) or a dollar in US treasuries? Beijing is making a statement. Some sane heads in Congress should pay attention.


I do not think China will make a massive "all-at-once" shift away from US treasuries. But they could certainly continue to re-deploy assets away from US treasuries. And they will likely be accompanied by other smaller central banks with large reserves as well. We could see some serious pressure on US government bond interest rates.


And it is interesting to note that the growth in Chinese exports was in large part delivered because of European markets. Europe is the new customer for China, and it makes sense then that they increase their euro holdings. But that is not dollar or interest rate bullish

i have started another thread on the investment implications of these flows.