Marshall Auerback: What US Treasury Yields Might Be Signalling

By Marshall Auerback, a market analyst and Research Associate at the Levy Institute

I’m fundamentally a deflationist at heart on the question as to how this mega moral hazard bubble finally resolves itself. This, in spite of the strong sudden explosive rise in the December US household measure of employment, (which has brought the smoothed household survey job growth up towards the stronger payroll survey job growth and seems to point toward further rate rises being engineered by the Federal Reserve as we move forward in 2016).

So why didn’t bonds plummet (and yields soar) last Friday, following the December rise of 485,000 jobs, which took the 3 month average to 329,000? (Prior to this report household survey employment growth averaged 119,000 a month for the nine months through November and 95,000 for the six months through November. Now the six-month average is 201,000 and the nine-month average is 177,000. ) For that I think we have to look toward China.

Even though China’s most recent data has shown signs of stabilization (and the current turmoil in the Chinese market will likely provide more Chinese policy stimulus via further overinvestment, which could perpetuate this capex bubble in the short term) it is likely that the US bond market is paying closer attention to the gradual unwinding of the country’s historically unprecedented investment ratio of around 45% to GDP. That ratio (down from a peak of 55%) suggests that China is poised to embark on a powerful accelerator multiplier dynamic to the downside. Add to that ongoing dollar strength, which has inflicted further deflationary pressures on resource producers, most particularly those who have borrowed dollars against declining resource revenues, all of which has put pressure on commodity prices.

And, as my friend Doug Noland has astutely noted in his most recent Credit Bubble Bulletin, “China’s reserves provide a crumbling foundation for confidence – internationally as well as domestically. Chinese officials might now seek to orchestrate a major currency devaluation and system reflation (comparable to past moves by the U.S., Japan and Europe). But they will face the traditional EM problem of flagging confidence – in their currency, in their banking and financial systems, in their economic structure and in policymaking. They risk further inciting destabilizing outflows – and the more aggressive Chinese fiscal and monetary stimulus the more precarious the ‘capital’ flight issue will become.”

While the commodities collapse has likely been exacerbated by the leveraged speculating community continuing to unwind several crowded “risk on” trades, there is a fundamental basis for the declines as well: namely the market intuiting a big devaluation of the RMB in the near future. Perhaps Beijing’s policy makers are contemplating that a big one-off devaluation of the RMB (15% ?), will put a floor on the “death by a thousand cuts” outflows to their currency, as well as helping to stabilize their dwindling foreign exchange reserve position once and for all. That’s certainly a risky approach for China’s policy makers, as it might well have the opposite impact.

But Beijing may have no choice. Authorities are quickly becoming fearful of pissing away all their international reserves. The wall of money from China may be coming to an end. They have the challenging task now of aggressive stimulus without inciting additional capital flight. A big devaluation to boost exports (and buttress forex reserves) might be seen as the preferred course of action, particularly given that China’s foreign debt position is relatively stable at around 10% of GDP.

It would not be the first time that China has gone in the direction of an aggressive devaluation. Today’s investors have short memories, but China undertook a huge cumulative devaluation of the RMB of 60% between 1992-94, which rendered the Tiger economies completely uncompetitive and turned their large current account sures into deficits very quickly. That was a key (but little appreciated) factor that helped to lay the groundwork for the 1997/98 Asian financial crisis.

So to return to the initial question posed, in spite of the strong employment data coming out of the US last Friday, I still think the deflationary tsunami coming from China is what is keeping US bond yields low, and China seems like the biggest reason for that If a bigger devaluation comes, China might also find itself forced to impose yet stricter capital controls (in spite recent liberalizing moves the past few years).

And that’s why I suspect that bond yields didn’t go up on Friday, in spite of the “strong” employment data in the US. Because the markets at some level intuit this huge deflationary blowback coming from China. The ongoing declines in the Chinese markets this week suggest that the recent interventions have not helped, given the magnitude of the challenges faced by Beijing.

One last point: The idea that China will behave “responsibly” is a crock. They have huge asymmetric political problems. If we get policy wrong in this country, voters have the right to pursue a change of government. Not so in China. So if their policy makers get it wrong, they likely go to the salt mines or (even worse) face firing squads. So the political imperatives point to Beijing looking out for China first, the international economic consequences be damned. What an irony a big devaluation would be, considering that years ago the “informed consensus” universally believed that the next big move for the RMB would be a substantial revaluation.

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15 comments

  1. Wade Riddick

    China’s private sector borrowing is considerable – far above 10% GDP – so devaluing the currency would cause an effective margin call on funds borrowed in dollars. The shortage of reserves would then tie policy makers’ hands with regards to monetary intervention to deal with the problems in collateral chains (which have been under extreme pressure since the bonded warehouse lending schemes started unraveling in copper and other commodities back in 2014).

    Or have I missed something here?

    Their stock market is already falling because of margin buying. Delaying the fall in the market by blocking stock sales has no doubt triggered defaults since many buyers won’t be able to cash out to repay the loans. Wealth management vehicles are probably already failing in this environment, like auction rate securities did eight years ago.

    I don’t think we’re paying enough attention to disappearances in the business community. China is enduring another purge of its middle class. This indicates severe crisis already. An elite split could be coming. The great fear in China is of dismemberment. The country is so large and populous, central power has always been tenuous. Most people don’t realize this fear of returning to local warlords is the main driver of Chinese policy, whether it comes to the economy or dealing with ethnic minorities. Rational economic policy may wind up having little to do with the ultimate response.

    Deflation is also a measure of cartels consolidating power in economies. What does China exporting deflation to the rest of the world tell us about the current international global “capitalist” order? Rent-seeking über alles?

    1. craazyboy

      China exports lower prices to western multinationals. It could just end there. How many Chinese consumer brands in the US can you name?

      1. abynormal

        One…Lenovo? but seriously there are suppose to be many by sometime in the near/far future. from 2010:

        1. craazyboy

          Yep. I remember reading about 10 years ago the Chinese government called for large Chinese companies to try and enter foreign markets directly. They acknowledged Chinese companies are at a disadvantage merely being the factory for western multinationals. But it is harder than it sounds.

          1. abynormal

            i know 7 local fusion rock and blues bands headed that way…can’t remember any Asian bands headed our way. i asked a few of our bands, how they were being paid…they didn’t care cause its all about ‘exposure’…oTay

            1. craazyboy

              Sounds like a potential TPP success story!

              Well, China isn’t part of TPP, so they’ll have to tour…

  2. Synoia

    What an irony a big devaluation would be, considering that years ago the “informed consensus” universally believed that the next big move for the RMB would be a substantial revaluation.

    Very smart “informed consensus.” It really make sense for a commodity manufacturer is take an action which make their labor costs noncompetitive.

  3. financial matters

    “I’m fundamentally a deflationist at heart on the question as to how this mega moral hazard bubble finally resolves itself.”

    I agree with this but think it’s important where the deflation takes place.

    Wray and Liu in a working paper commissioned by the Asian Development Bank,
    Options for China in a Dollar Standard World: A Sovereign Currency Approach, ,
    make the point that China should use it’s sovereign currency power to counteract the local generation of credit though the shadow banking system.

    “”Shadow banking in China assumes various guises. The most basic are the illegal loan sharks who operate mainly in wealthy coastal regions, providing high-interest loans to small businesses that are often ignored by mainstream banks. But most of China’s shadow banking is legal. The biggest of the non-bank institutions are trusts, companies akin to hedge funds. They cater to rich investors and promise high returns by lending to risky customers, especially property developers. A range of industrial companies, from shipbuilders to oil majors, also engage in shadow banking as a side business. Estimates about the size of shadow banking vary widely depending on how it is defined. Tying together various threads of official data, UBS economist Wang Tao believes it is no smaller than Rmb13.6tn ($2tn), or about one quarter of this year’s gross domestic product, and could be as big as Rmb24.4tn, or nearly 50 per cent of GDP.””

    They make the point that China should try and slowly deflate this risky system while stimulating the country centrally with it’s sovereign currency ability to increase local demand in a more distributive manner and to increase social services such as medical and educational.

    1. Jeff

      It’s more possible to do this in China than in the west, but I think “Deflate the bubble while propping up the people” is kind of the ideal scenario when some sort of financial bubble bursts. The bubble collapse would take a lot of money away from the people who were profiting and the government can either print money or borrow and just hand out cash broadly to the lower middle class and poor. In China it would also probably rebalance the economy towards consumption as the poor go out and buy the excess housing and etc.

    2. Yves Smith Post author

      The problem is that Wray and Liu implicitly assume that China has the institutional wherewithal to do that. Recall in the US that we didn’t have enough “shovel ready” infrastructure projects to drive payments to local construction workers on anything resembling a timely basis in 2009 (Obama has generating “manly man” jobs as a priority).

      The central government does not have a local infrastructure. The regional and local governments are largely independent fiefdoms, from what I can tell. And China could not implement something like Richard Nixon’s revenue sharing, where the Federal government gave states $ to spend on local priorities, with sufficient oversight to prevent corruption. The state and local government corruption in China is rampant compared to the US of the 1970s and 1980s. I don’t see how you get the money in the hands of non-rich Chinese citizens without tons of it being diverted by the rich and politically connected.

  4. David

    David Stockman:

    “According to the BLS, the US economy generated a minuscule 11,000 jobs in the month of December……….the BLS fiction writers added 281,000 to their headline number to cover the “seasonal adjustment.”

    why isn’t this a more plausible explanation? That is – no one believes the BS @ BLS

    1. Paul Tioxon

      If December jobs report is just temp Xmas filling in for the crush of shoppers at malls, stores and on line, it isn’t all that obvious from many local Walmarts, Targets, etc, who seem to add very little extra help despite the huge numbers reported of 70,000 here or 50,000 extra Xmas help there. Anecdotes abound of check out lines staffed by regular stocking staff and not new hires at Walmart and Target around here. And the cover story is can’t hire with an arrest record and/or pass a drug test. Decent people who are willing and able show up on time for work and are not teens staring at their smart phones all day are not at all attracted to $9/hr work for 20 hours a week that lasts only 10 weeks at best. Big box stores seem to be replicating the abandoned service motif of department stores. Except this time around it is showing up in check out lines that are understaffed and in a pinch pull people away from their regular duties to the detriment of a neat, well stock store.

  5. papicek

    Mechanistic explanations of economic & market activity ring hollow to me and this is no exception. Much too overthought. The answer is quite simple: markets were ok with the rate hike and have been for at least 18 months. Call it sentiment, call it a move telegraphed like none other in history, whatever. I keep telling people the only 2 things they need to consider when looking at a market are its permissions and expectations and realize that fundamentally, the market operates with the [mis]rule of the mob.

    I think you’ll always find that this simple answer is durable. It always suffices.

  6. Jim Haygood

    ‘Bond yields didn’t go up on Friday, in spite of the “strong” employment data in the US.’

    Funny, that’s what happened from mid-2003 (when the first green shoots of recovery appeared) until early 2006, when Greenspan’s reign of error ended.

    Greenspan had hiked the Fed’s policy rate from a low, low 1.0% in mid-2004 up to 4.5% when the Bernank took the wheel. But 10-year Treasury yields remained in a complacent range of 4 to 5% the whole time, paying no attention to the bizarre little man behind the curtain with the Mr Magoo glasses.

    J-Yel is attempting to hike rates on a disinflationary world. J-Yel and Ms Market are locked in a high-noon standoff. Ms Market will be happy to keep puking on J-Yel’s valuable Oriental rug until J-Yel and her liquidationist sidekick Stanley Fischer capitulate.

    Next week we should get the 4th quarter report from the biggest bond bulls on the planet, Hoisington Management. Probably they’ll conclude the same way they did last quarter:

    Nothing [is being done] to ameliorate the over-indebtedness of the nation or address the structural problems of future claims on our federal and state budget revenues.

    History suggests that such a condition engenders a long period of low inflation and thus low long-term
    interest rates. Therefore a position in long-term government bonds continues to be our investment stance.

    Long govies — a life preserver in disinflationary seas.

  7. Tim

    Employment is a very lagging indicator.

    Better to focus on new orders and inventory in the US itself (new orders+backlogs-inventory).
    These are way down and are now at levels that have only occurred in previous recessions.
    Plus there seems to be a bad omen coming from shipping, BDI is way down and apparently there are very few ships actually moving, in the Atlantic anyway, according to zerohedge.

    This is what I think the bond market is focusing on, China adds a nice tailwind.
    It may not mean recession but it probably means very slow growth.

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