Sunday, March 22, 2009

Musings About Treasuries - Can We Make Sense Of Them Anymore?

A term which you are going to hear a lot in the coming weeks is "quantitative easing" which, put very simply, refers to the practice of central banks creating money. On March 6th, The Bank of England announced £150bn of quantitative easing, increasing the risk of inflation in the UK and now the US is following suit. The FOMC announced this week that it would purchase $300 billion worth of longer term US treasuries over the next six months. Unsurprisingly, this announcement caused the US dollar (USD) to fall, particularly against the euro (EUR), and the price of gold to jump.

The Chinese government has the world's largest holding of US treasuries and has recently openly expressed their discontent over the devaluing nature of the US government's activities toward their investment. If they were to fear that the value of their holdings was going to decline, they would most likely be obliged to sell them off and salvage whatever value they can before the market for US treasuries crashes. Which leads me to an interesting supposition, that the Federal Reserve is not going to be buying freshly created treasuries, which would have a strong inflationary effect, but in actual fact is going to buying existing treasuries from China! This in turn carries with it the implication that the Chinese will not be purchasing any more new treasuries from the US in the near future, increasing speculation that the Federal Reserve is set on devaluing the US dollar (USD), thus inflating asset values.

Of course, there are deeper implications to this as this effectively gives China the chance to increase its share of the global market and continue with its incredible economic growth. The credibility and influence of the US government over China is weakening, and attempts to coerce China into allowing the yuan (CNY) to appreciate will likely fall on deaf ears. There is even the scary possibility that China may decide to devalue the yuan (CNY) as the US dollar (USD) begins to slide. This will effectively bolster the Chinese economy and increase global market share. Of course, in practice it cannot be that simple, as the US government can always retaliate by increasing import taxes on Chinese goods and before you know it, the global depression is worse than it was to start with!

I believe that the discussion of the Chinese yuan's (CNY) valuation is going to be high on everyone's agendas in the coming weeks, particularly following the FOMC's move to devalue the US dollar (USD). Added to which we are likely to see some real fireworks in the treasury market. The outrage following the AIG bonus scandal will soon pale into insignificance in the light of more important events with much more dire consequences. I don't for one second buy into the heavily touted deflation banter and think that we're in for steady paced inflation in the upcoming months.

I expect continuing increases in the price of oil, gold and other commodities, and I ultimately fear a collapse in the treasury market. The collapse when it comes leaves me with the fear in the back of my mind that there is a strong probability that the US will have to default on its debts, as they cannot keep on printing money indefinitely. I do anticipate that the eurozone will crash first, which may somehow enable the US to crawl from the wreckage intact, but either way I don't believe the ride is close to being over.

Disclosure: At the time of writing the author held shares in ProShares Ultrashort 20+ Year Treasury ETF (TBT).

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