Sunday, March 22, 2009

The Art Of Finance

Taipan Daily: China, the Fed and Financial MADness Revisited

by Justice Litle

Well, they did it. They pulled out the big guns – and caught the world by surprise.
The Financial Times called it “shock and awe,” further adding that “Federal Reserve plan stuns investors.”
A Seeking Alpha contributor suggested that “Helicopter Ben” (as in Ben Bernanke, the Chairman of the Federal Reserve) should have his nickname changed to “ICBM Ben,” as in Inter-Continental Ballistic Missile.
MarketWatch elected to play it straight in their headlines: “Treasury yields drop most since 1987,” they said, following that up with “Dollar plunges after Fed says it will buy Treasuries.”
Not only did the dollar plunge, but gold moved sharply higher at the same time on Wednesday – thus breaking the remarkably odd coupling that had persisted these past few months.
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In addition to its role as an inflation barometer, gold is a form of crisis insurance. Meanwhile U.S. government bonds (which one must pay for with dollars) are a form of deflation insurance.
And so, when gold and the dollar are rising simultaneously, the global economy is in a world of hurt. To see gold and the greenback break apart now – like two temporarily fused magnets returning to opposite polarity – thus might well note the end of the global deflation trade.
A week ago, we noted that something like this could happen. Those who expected deflation to persist had forgotten that “the Fed has not gone crazy yet” (See March 13 piece, Is Gold on “Deflationary Death Watch”? ).
We can also dial back a little further, to the January 7 Taipan Daily titled, “Don’t Stay Short Treasuries – Short the Dollar Instead,” and find this little nugget:
If the Fed intervenes to support treasuries (in order to keep interest rates low), they will do so at the expense of the greenback. The Fed has to print dollars, or otherwise release dollars, in order to buy USTs in the open market.
And so they did. As bonds soared, the dollar crashed. To defeat the deflationary Mothra once and for all, Ben Bernanke has sounded the Godzilla call.
Solving a Mystery
I’ll admit, Bernanke had me fooled for a bit. He fooled a lot of people with his dormancy. Though the Fed hinted at buying treasuries in December of 2008, enough time had passed that it looked like they wouldn’t do it after all.
In Macro Trader (my trading service), the Fed’s bold move caught us by surprise – as it caught most everyone by surprise – but fortunately we were already short the dollar and long hard assets (including oil and gold) via various instruments when the big announcement went down. (We are still making hay from those positions, and just yesterday booked 92% half profits on our bearish dollar play.)
So why did the Fed decide to go for the gusto (and trash the dollar in the process)? Why now, this week? What follows is an excerpt from the “Weekly Briefing” I send out on Thursdays to Macro Trader members:
Let’s be clear, this move was a total shock. “Nobody expected such explicit stuff,” portfolio manager Joseph Balestrino said. “It’s good news for markets but bad news because it means the other stuff isn’t working. Things are terrible by the Fed’s own admission.”
But if things were terrible, why had stocks been rallying? After all, markets had seemed to be improving on their own before the Fed’s big move.
The banks had already rallied hard... stocks were already going back up... and the Consumer Price Index rose in February by the highest amount in seven months.
So it was exceedingly strange for the Fed to engage in this “shock and awe” treasury buying exercise after so many signs of improvement had already been coming in.
There are a few theories as to why the Fed acted out of the blue, stunning investors the way they did:
1) Ben Bernanke knows something truly awful about the banks that no one else does... yet... and decided to get ahead of the curve by buying up USTs now.
2) The Fed was afraid that public outrage at the AIG bonuses had become so strong that no more bailout money would be forthcoming from Congress. Buying treasuries thus became the alternative.
3) Foreign purchases of U.S. Treasuries were starting to dry up, and the lack of buyers for future treasury issues looked ominous.
Of those three options, we can only guess which is right of course... but my vote is for number three.
Debt watchers who pay attention to the supply and demand flow for treasuries note that recent numbers looked “horrible.” Economist and blogger Brad Setser further noted this week that “foreign demand for long-term Treasuries has faded.”
This makes sense. The global exporters no longer have huge trade surpluses to recycle back into U.S. Treasury bonds. Newly optimistic investors are buying fewer Treasury bonds. China is electing to spend its cash horde in different spots around the globe, going on a natural resource buying spree, and has less money for Treasury bonds anyway now that it isn’t exporting as much.
And so, the Fed may well have felt the need to preemptively position itself as a buyer of last resort for treasuries BEFORE something really ugly happened.
Financial MADness
So that’s my guess... the Fed chose to act aggressively, at what seemed to be an odd time, because they feared the bottom was about to fall of the U.S. government bond market.
Sort of a perverse logic, really. Things were looking so weak in Treasury land, emergency actions led to a short-term boost of colossal strength.
China may have had a role to play in the Fed’s actions too. Is it a coincidence that just last week, Chinese Premier Wen Jiabao voiced that he was “very worried” about the safety of China’s UST holdings?
To explore that angle, let’s go way, WAY back now – all the way to May 2005.
Nearly four years ago, I wrote a piece for the Daily Reckoning called “Financial MADness.” (You can still pull that piece up here.) What follows is the relevant excerpt. (Note too that four years on, the $600 billion figure has morphed into $1.9 trillion or so, an estimated two-thirds of that being U.S. treasuries.)
As of year-end 2004, China had more than $600 billion in U.S. dollar reserves. That is a sum that could effectively tear the financial plumbing system apart if it were unceremoniously dumped on the markets. With such massive pressure, in a compressed period of time, the pipes would surely burst. Of course, this would be fiscal suicide for the dumpers as well, which is precisely why such a move is not feared. China’s own economy would be sucked into the vortex too, so why would the Chinese put a gun to their own heads?
The theme that applies here is the doctrine of mutually assured destruction, or MAD – but of the financial sort, rather than the nuclear.
A product of the 1950s, the doctrine of MAD essentially states that two parties with the capacity to destroy each other will recognize the folly of hostilities. We liquidate the Soviet Union, they liquidate us and nobody wins. So peace is assured, right? Wrong. The flaw in the theory comes in the form of a question: What happens if one side or the other is thrown into political turmoil, or if the reins are taken over by madmen with nothing to lose?
A Communist Party leadership on the edge of collapse would make a last-ditch bid for stability by any means necessary, which in turn would make it willing to contemplate the financial-Armageddon option, as a form of extreme blackmail, if its hand were forced. If the mandarins feared implosion, they would have the means to not just ask for extraordinary coordination from the United States and Japan, but to demand it… on pain of catastrophic consequences if they were allowed to fall.
But is this a point in favor of the optimists or the pessimists? Obviously, it’s not a pleasant thought to imagine a breakdown in China’s economy sparking massive civil unrest, in turn leading to a “hot war” with Taiwan as a means of distraction and a catalyst for unifying nationalism, which by extension draws in the United States and sets the stage for the grand finale: the financial equivalent of a hydrogen bomb going off as hostilities escalate out of control.
Fun stuff eh? That whole line of thought was basically back-burnered for four years, as the good times rolled on and China’s economy powered along with it.
But now, the seats at the top of China’s leadership pyramid are starting to look shaky again. The doctrine of Financial MADness has become newly relevant – as the Fed’s unprecedented intervention in the treasury market may have shown.
Bicycles and Tables
Meanwhile, global markets are showing clear signs of recovery – for now – but China’s ability to maintain stability and growth has become an open question. Minxin Pei, an associate with the Carnegie Endowment for International Peace, wonders openly whether China’s Communist Party will “survive” the crisis.
Until recently, most leading China watchers thought the Chinese Communist Party (CCP) had become remarkably resilient... Because of the global economic crisis, however, Beijing is in trouble. The problems are numerous: China's exports are plummeting, tens of millions of migrant laborers have lost their jobs, millions of college graduates cannot find employment, industrial overcapacity is threatening deflation, and the once red-hot real estate sector has nose-dived. The country's faltering growth is posing the hardest test yet to the CCP's resilience.
As financial blogger David Merkel has observed, there is a difference between “table stability” and “bicycle stability.” Table stability implies a solid situation in the absence of change. Bicycle stability implies that things have to keep moving forward.
A table, in other words, can just sit there. But as soon as the bicycle stops, it falls over. In China’s case, one might say it’s the bicycle factories that have to keep moving forward... lest the whole social order fall over as millions of angry Chinese protest against the permanent disappearance of their jobs.
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Intriguing Maneuvers
Make no mistake – Beijing still sits on a mountain of cash. More than half a trillion bucks’ worth of stimulus is wending its way into the system, and there is plenty more dough where that came from in the form of Chinese reserves.
Whether those cash reserves will be enough to keep China growing is the real question. The possibility that it won’t be enough is what keeps the mandarins awake at night... and possibly leaning hard on the Fed.
Your humble editor wonders, too, whether China’s recent commodity-buying spree and the Fed’s treasury-buying binge could have a secret hidden connection. Consider this nugget from The Washington Post:
Chinese companies have been on a shopping spree in the past month, snapping up tens of billions of dollars' worth of key assets in Iran, Brazil, Russia, Venezuela, Australia and France in a global fire sale set off by the financial crisis.
The deals have allowed China to lock up supplies of oil, minerals, metals and other strategic natural resources it needs to continue to fuel its growth.
Could it be that China knew in advance the Fed was going to step in and buy Treasuries – a friendly “heads up” from one government to another, or even a negotiated arrangement of sorts?
Could it further be that Chinese officials knew the dollar would crash on such Fed actions... a crash telegraphed to them but few others... and thus decided to step up their hard asset buying BEFORE the big event, with the foreknowledge that commodities were set to catch a bid?
However complex this web of intrigue might be, the charts at least are fairly straightforward. With the dollar folding like a cheap tent, China writing fat checks around the globe, and major commodities like oil and copper working out a clear bottoming process, hard assets look like an easy buy.

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