谢国忠 Andy Xie: Fear the Dark Side of China's Lending Surge

Here's a long and important section of Andy Xie's latest:

The current surge in commodity prices, for example, is being fueled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

Commodity prices have skyrocketed since March. The Reuters-Jefferies CRB Index has risen by about one-third. Several important commodities such as oil and copper have doubled in value from this year's lows. As I have argued before, demand from financial buyers is driving commodity prices. The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.

Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.

Financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.

Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.

For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China's size. They've made everything open to speculation.

The worldwide rally of commodities and equities is a speculation led bubble based on future growth expectations that have no basis in reality. Economic data continue to point to a very weak U.S. economy, check out a recent post by Mish on truck and rail traffic. The Baltic Index is up because the Chinese demand requires shipment of commodities, but rail traffic in the U.S. doesn't show resource demand.

Andy Xie's comments on ETFs and the implications for monetary policy are important. Never before have commodity markets been so accessible to retail investors, yet the commodity markets themselves remain relatively small compared to stock and bond markets. There's a lot of room for growth, should investors decide they want out of equities and into commodities. This also means investors can exit the U.S. dollar and financial assets at a moment's notice.

In the early 1980s, Ed Yardeni dubbed the inflation hawks in the bond market "bond vigilantes". Today, there are still bond vigilantes, but now retail investors can join the game via derivative ETFs such as ProShares Ultra Short 20+ Year Treasury (TBT), or various commodity ETFs such as SPDR Gold Shares (GLD), PowerShares DB Agriculture (DBA) or PowerShares DB Oil (DBO).

Financial markets don't do what everyone is expecting though—"the market" is the master of misdirection. If investors anticipate high inflation, they will pour into commodity funds and drive up interest rates. The government may try to restrict commodity speculation, and that could be a part of upcoming financial reforms. Otherwise, the Federal Reserve and other central banks will be forced to raise interest rates and drain liquidity from the system, and that will touch off another round of deflation.

The speculators are in the driver's seat because they suspect (many would say they "know") that the government finds another deflationary event unacceptable. They are playing chicken with the central bank because they believe central banks will swerve their inflationary Fiat in the face of the deflationary Mack truck. The behavior of speculators guarantees very high inflation if the central banks do not curtail credit. In order to have the "healthy" inflation the central banks want, they must restrict access to commodity markets and/or chase the speculators out. A well-timed liquidity drain or surprise rate hike would put the central bankers in the driver's seat of the Mack truck and leave the speculators packed in the Fiat.

I do not believe the central banks can create the inflation they desire while the world is watching. There is a natural law underpinning the world that cannot be defied for long. In the absence of central bank inflation, speculators are setting up the next round of deflation as high resource costs drain the pockets of consumers and business alike. The central banks cannot print money unless people are willing to hold it, i.e .unless there is a healthy demand. Recently, demand for cash was so strong that the velocity of money plummeted. In a high velocity environment, with very low demand for money, central bank printing is suicidal. The central bankers need to keep demand high, and they will do by keeping the spectre of deflation alive. Without it, they can only fail.

The Federal Reserve is clueless

Really, the Federal Reserve doesn't understand what is happening in the government debt markets. I hope Reuters analyst Alister Bull has made an error and the Federal Reserve does not actually believe the second paragraph below:

Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit? If so, there might be less need for the Fed to expand the money supply by buying more U.S. Treasuries.

Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar as the Fed floods the world with newly minted currency as part of its quantitative easing program. This might be an argument to augment to step up asset purchases.

Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.

Quantitative easing is the reason people are worried about a U.S. dollar collapse. Stepping up quantitative easing will not solve the problem, it will exacerbate it. All QE can achieve is the lowering of interest rates. On the issue of central banks such as China reducing long-term bond purchases, in my post Crowding Out has arrived, I linked to the Brad Sester post that shows this is exactly the case.

Read the whole article. The Federal Reserve has no idea what it going on, yet they are pursuing the most interventionist policy in their history. Does that inspire confidence? I've mentioned TBT and PST before, two ETFs that deliver the double inverse of the daily change in Treasuries. The above is why the trade carries risk above and beyond their leveraged nature.

Unfortunately, it doesn't appear the Reuters story was wrong on the facts, Bloomberg has a similar story out today:Treasuries, Dollar ‘Only Game in Town’ as China Buys.

Fed officials see several possible explanations for the rise in yields. One is the outlook for the economy is improving and investors are selling government debt used as a hedge against mortgage securities.

Another is the supply of Treasuries for sale exceeds the Fed’s so-called quantitative easing program. After cutting its target interest rate for overnight loans between banks to almost zero, the central bank pledged to buy as much as $300 billion of Treasuries and $1.25 trillion of bonds backed by mortgages to cap borrowing costs.

That confirms what Reuters reported about the Fed believing their asset purchases may not be sufficient. The article also goes on to mention central bank purchases, mentioning China specifically:

China increased its holdings by 3.2 percent, the most since November, buying Treasuries with its reserves to control the level of the yuan. The currency, which was pegged at about 8 to the dollar until July 2005, has traded between 6.8 and 6.9 since last June. It closed May 29 at 6.8291 to the dollar.

“To some extent they have to buy Treasuries because they want to support their currency peg,” said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities USA LLC. The firm is also a primary dealer.

China can cease purchasing Treasuries as soon as they decide to allow the yuan to appreciate. The article goes on to discuss "bond vigilantes", sovereign credit ratings, and Fed policy, and then this:

Indirect bidders, a group that includes foreign central banks, purchased 54.4 percent of the $40 billion in two-year notes sold May 26, the biggest percentage since November 2006, according to the Treasury. They bought 44.2 percent of the $35 billion five-year notes auctioned May 27, compared with an average of 32.4 percent at the previous 10 sales. The scooped up 33 percent of the $26 billion of seven-year notes offered on May 28, matching the average of the other three sales this year.

“The idea that we have lost sponsorship at the auctions seems farfetched,” said Ian Lyngen, an interest-rate strategist in Greenwich, Connecticut at RBS Securities Inc., another primary dealer.

Central banks purchased a larger percentage of bonds on the day rates tumbled. The simplest explanation is that outside of central banks, there isn't much private demand for government paper, the old argument for crowding out, considering the action in mortgage markets. Please see Mish Shedlock's post,"Mortgage Market Locks Up". Mish also covered the Federal Reserve's failure on Wednesday in a post titled: Treasuries Massacred; Yield Curve Steepest On Record
Check out his post, which includes the following quote from Fil Zucchi, "As I publicly asked before, if Mr. Fed can't rig the price of an asset by buying it with printed money, why should anyone else buy it?" The chart above indicates few have found an answer to that question.

Crowding Out has arrived

I remember learning the crowding out theory in economics class, which says that government spending and borrowing "crowds out" private spending and borrowing. For the longest time, however, there was little evidence that government borrowing was crowding out private borrowing, probably due to the fact that the U.S. was in the midst of a multi-decade credit expansion. If there was an effect, it was muted.

No longer. Brad Sester shows why Treasury rates are rising now—central banks reduced their demand for long-term Treasuries, leaving private borrowers to pick up the slack.

Over the last 12 months of data (data through the end of April, May data will be out soon), the US issued $735 billion of notes, bonds and TIPs.* In calendar 2008, the increase in supply of longer-term Treasuries was about $400b – a large sum, but easily within the realm of historical experience.

Yet even as the supply of notes has increased, central bank for longer-term Treasuries for their reserves has fallen. Central bank demand for longer-term Treasuries – on a rolling 12m basis – has been trending down since August 2008.

It's a situation that will only grow worse in the coming months and years. ProsShares Ultra Short Barclays 20+ Year Treasury (TBT) is one of the few ways to profit from the trend.

Here's an article discussing potential crowding out in China.

I'm Boycotting Treasuries

Although I haven't taken a position yet because I expect further deflation, I have my eye on these two double inverse ETFs. ProShares UltraShort 20+ Year Treasury (TBT) and ProShares UltraShort 7-10 Year Treasury (PST).

Japanese yields have fallen for more than 10 years though...I may be watching this a long, long time.