Identifying a Treasury Crash
Guest post by Azizonomics.
Here’s a reminder for those of you with short memory spans, or new readers:
There are two very strong pieces of evidence here for dollar and treasury weakness: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when (not if) these perceptions will be shattered.
A large sovereign treasury dumper (i.e. China with its $1+ trillion of treasury holdings) throwing a significant portion of these onto the open market would very quickly outpace the dogmatic institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike actually corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the (hugely dogmatic) market panic enough to cause a treasury crash is the pace and scope of liquidation.
Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.
But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:
- China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
- China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”
- Both of the above.
If such an event was big enough to cause yields to spike 1% (very conservative estimate) it would jar the status quo enough to trigger a significant gold spike, as funds and banks move to cash positions (sensing both the post-crash buying opportunities, and margin hikes) and seek to “hedge tail risk”.
Now the pace and scope of China’s coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.
So here’s the relevant data:
Does this look like that to you? Well, frankly, no. China’s holdings have merely declined to 2010 levels — hardly a nosedive, but certainly signifying China’s lukewarmness toward the Obama-Bernanke administrations. Right now they are just testing the water.
And certainly, the increase in the Fed’s holdings is symptomatic of Bernanke acting to force rates lower and spare the Treasury some heat. Significantly, rates have risen in the past few days, signalling that even in spite of all the QE and Twisting, Bernanke’s task remains volatile.
So — while it is all very easy and attention-grabbing to spew fear-mongering projections of an imminent crash — I have to be realistic. 2013 or 2014 or even later seems a much likelier timeframe for this momentous and historic eventuality. And of course, black swans can derail any projection. Humans will always be fallible, no matter how much processing power we put behind our prognostications.
So there is really no timeframe to my prediction. Certainly, Bernanke has proven himself to be a proficient can-kicker. Too many decent economists have scuppered their reputations by making timed predictions which fail to play out, even though the fundamentals of their view are sound.
And my prediction is not an economic prediction, so much as a geopolitical one, and political science is an oxymoron; politics (like any other market — yes, it’s a market to be bought and sold) can swerve and tilt in any direction in the time-being, even while its broader historical trends are clear and self-evident. (In this case, the rise of China, the end of American primacy, and the death of the dollar as a reserve currency).
The strongest position is one that will thrive under all eventualities (another reason beyond counter-party fragility why derivatives and other zero-sum strategies are so fragile).