Chinese Bailout May Send U.S. Interest Rates Higher

Over the weekend, China announced a $586 billion "stimulus plan" for its slowing economy.

China is in a precarious position as the world economy grinds to a halt. Out of its 1.3 billion people, most have not participated in the economic boom the greater country has experienced.

Let me know if this sounds familiar - the rich have gotten richer, while the poor have stayed, well, relatively poor. As a side note, you can see there is nothing unique, wrong, or evil about this phenomenon that has taken place in the US. It's the way of nature - the greater the progress, the more of a gap that develops between the haves and have nots - a topic we could explore at great length in and of itself.

Back to China: the majority of the population still lives in the countryside, and the majority of the population is still poor. And they do not like seeing their fellow countrymen get rich without their fair share (sound familiar again?)

To this point, the Chinese government has been able to pacify the masses with sufficient government bread and circuses, as long as the economy continues to hum. But the Chinese state, as currently constituted, may not be able to survive a deep recession, at least without a potential revolution from its countryside.

Historically, most Chinese uprisings originate from the countryside. Expect the Chinese government to do whatever is necessary to prevent a severe slowdown. They must establish domestic demand for their products and stop relying on exports, and they must do it soon.

I think they'll be able to hold things together. Unlike the US, the balance sheet of China (both consumers and the greater government) is quite plush right now. The Chinese save a lot of their money, and they have sufficient capital to get through this - not to mention if/when they really catch on to credit cards, which we saw evidence of earlier this summer.

So what does this all have to do with interest rates in the US? The Chinese government will have less money to stash in US Treasuries - which will put a significant dent in the demand for US Treasuries - which should send rates up, up, and up.

And how about the supply side of the equation? Looks like that's about to skyrocket also. From Bloomberg:

The US government's borrowing needs will almost double to $2 trillion this fiscal year, prompting the Treasury to revive three-year notes and hold more frequent sales of 10- and 30-year debt.

Add these to reasons that I previously outlined, and it appears we have a recipe for skyrocketing long term interest rates.

How can you participate in this trade? I'd suggest looking at the ETF TBT, which was suggested by several of our readers here, and probably the easiest way to short long-dated treasuries. By buying TBT, you are essentially placing a leveraged short on long-dated treasuries.

TLT is another potential play - it's the inverse of TBT, so you'd want to short it. For what it's worth, legendary trader Dennis Gartman said he prefers a long TBT position to a short TLT position.

Disclosure: I do not hold any positions in these ETFs, but I am short 10-year treasuries via the futures market.

Comments

[huangthomas:]

It is almost a "requirement" for the exporting countries to use their trade surplus to purchase US treasuries. This has been an open secret for decades. As the US economy slumps, we import less from China, Chinese trade surplus decrease. There will be less money for China to purchase US treasuries, yet US needs for borrowing will undoubtedly increase to save our economy. Two trillion plus Chinese foreign exchange reserve are already loaded up with US treasuries. CNY 4 trillion stimulation package would undoubtedly be a deficit spending. Only Fed can decide the interest rate level. I don't think Fed will allow it to sky rocketing to shoot down US economy.

2008 Nov 11 10:33 AM

[HaavBline:]

I already own TBT for 3 weeks based on the very same rationale described by the author. However, I am not sure the scenario of higher long term Treasury rates will happen very quickly.

The global recession is in a early stage and US creditors are too scared to push the subject of credit worthyness of US soverign debt. China, Japan, Middle East and other creditors will have to paly their 'stakeholder' role and continue to buy Treasury debt at lousy risk/reward ratios for some time until global economy begins to recover. That is when Treasury rates will begin to rise.

2008 Nov 11 06:56 PM