A Taste of the Orient

I am once again under the weather (but improving). The bright side (for me at least) is that I have the opportunity to write. Yesterday, prices of long-term treasuries rallied as China raised its bank reserve requirements in an effort to curb bank lending to slow down its over heating economy. Chinese policy makers are trying to avert a bubble. The result will be (if successful) is that China's ability to lead the globe out of the economic doldrums will be impaired. Other results are as follows. Chinese domestic consumption should moderate. This means that foreign companies counting on the Chinese consumer for a significant portion of its revenues will be disappointed. One report last week indicated that although Chinese auto sales were up about 50% in 2009, they are expected to rise only by 5% or 6% in 2010 and that was before yesterday's news.

Another outcome of China's policy change will be more U.S. asset purchases. If Chinese banks need to hold reserves, they will hold in dollars. Global growth will also slow. This means more buying of U.S. dollar-denominated securities as exporting nations seek to keep currency exchange rates favorable versus the U.S attempting to maintain what is likely to be a smaller U.S. consumer market (but still the largest in the world by far). This means that today's 10-year treasury reopening auction should garner much business from foreign central banks.

In response to the aforementioned developments I have sold my position in TBT. I still believe that the general tend for long-term rates is higher, this could be a speed bump at that journey and I believe I will be able to re-establish a long position in the near future. Investors buying floating rate securities of any type will are likely to experience underperformance, especially in terms of coupon performance. This is true of both LIBOR-based floaters and the poorly-described CPI floaters. Why? The Fed is not raising the Fed Funds rate anytime soon, possibly not at all in 2010. Also, the year-over-year change of the rate of inflation, as measured by the CPI Urban Consumer Index Non Seasonally Adjusted (CPURNSA) is not likely to be great anytime soon. Floaters to way too rich given the probable economic and interest rate conditions we are likely to experience.

There are opportunities out there. Why is anyone holding corporate bonds in the industrial sector (anything non bank, finance, telecom or utility) inside of five years? Government agencies are between 100 and 250 basis points cheaper in the 2 to 5 year area. Don't be worried about Freddie or Fannie debt. Those bonds have an effective, but not explicit, government guarantee. It is EXTREMELY unlikely GSE bonds would be permitted to default as it is the GSEs alone which are preventing an implosion of the mortgage market. Why own a 5-year Walmart Bond yielding 2.00% when one can buy a 5-year callable agency bond yielding 3.50%?

Have a nice day