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Monday, August 16, 2010 2:23 PM


China Net Seller of Treasuries; Yield Curve Flattens and Treasuries Rally; Recession or Depression?


Treasury bears have been waiting a long time for China to start selling treasuries. It finally happened (not that two months is that much of a trend). Nonetheless, treasury bears got their wish. The result was not what they expected but it is what I expected: US demand picked up.

Please consider U.S. 10-Year Yield Drops to 16-Month Low, Narrows Yield Curve

Treasury 10-year note yields fell to their lowest level in more than 16 months as reports showed manufacturing in the New York region expanded less than forecast and foreign purchases of U.S. government debt climbed.

Two-year note yields dropped to a record low as the Federal Reserve prepared to buy Treasuries tomorrow as part of its plan to spur the slowing economy by keeping borrowing costs low. The difference between yields on 2- and 10-year note yields narrowed for a third day to the flattest yield curve since April 2009. A report from the National Association of Home Builders/Wells Fargo showed builders unexpectedly turned pessimistic.
Do Economists Ever Expect Bad News?

Economists' consensus forecast for unemployment, GDP, interest rates, consumer spending, manufacturing and darn near everything else has been far too optimistic for years. What it takes for them to realize things are not going well and are likely to continue to not go well remains a mystery.
“We are heading back to a weaker economy,” said Theodore Ake, head of Treasury trading at Societe Generale in New York. “It feels like a recession, even though we are not in one. We are creating another bubble, but it won’t burst for one to two- years.”
Recession or Depression?

Given that the NBER never declared the end to the recession that started in 2007, how does Ake (or anyone) know we are not in a recession?

The proper question is not "Are we in a recession?" but rather "Is this a recession or a depression?" I think we are in a depression.
The difference between yields on 2- and 10-year notes narrowed to 2.09 percentage points. The so-called yield curve typically flattens when investors anticipate a slowdown. It widens when investors anticipate a recovery because they demand more compensation for the risk that growth will spark inflation.

Global demand for long-term U.S. financial assets rose in June from a month earlier as investors abroad bought Treasuries and agency debt and sold stocks, the Treasury Department reported today in Washington. Net buying of long-term equities, notes and bonds totaled $44.4 billion for the month, compared with net purchases of $35.3 billion in May.

The report also showed China’s holdings of long-term Treasuries fell for the first time in 15 months to $839.7 billion, a 2.5 percent drop. Its overall Treasury position declined for a second month to $843.7 billion, the lowest since May 2009. The decline represents the first year-over-year decline in China’s Treasury holdings since 2001. The holdings peaked in July 2009 at $939.9 billion.

“June represents a relatively weak month of debt buying,” David Ader, head of U.S. government bond strategy at CRT Capital Group LLC in Stamford, Connecticut, wrote in a note to clients today. “What is notable is China’s selling of coupons.”
Notable Happenings

The notable happening is not China's selling of treasuries. That selling is perhaps an outlier, a random fluctuation, or more likely a direct result of increased US demand.

Rather the notable happening is the massive rally in treasuries in spite of Chinese selling.
“The pace of economic recovery is likely to be more modest in the near term than had been anticipated,” the Fed said Aug. 10. It announced it will invest the principal payments from its holdings of mortgage-backed securities into longer-term Treasury securities in the same statement.
Manipulation? Of Course!

No doubt treasury bears will look at that paragraph and scream "We Waz Robbed". The reality is ...

1. Fed cannot change the trend; The Fed can only goose the trend or slow it down.
2. The economy was clearly weakening.
3. It was pretty clear the Fed would resort to these tactics when the economy weakened.

Thus, there was no reason to be shorting treasuries, and there still isn't.

Massive Treasury Rally Continues



The above chart courtesy of Bloomberg.

Once again the rally is across the board with the longer dated treasuries gaining the most. Note that 7-year treasuries are below 2%!

Yield Curve May 2008 to Present



click on chart for sharper image.

For about a month the long bond yield was on a shelf of support at or near 4%. It has been on a tear since then, with yields dropping the most of any spot on the curve.

This is not bullish for equities, nor is it a "deflation scare".

This IS deflation at work. After a respite in 2009, the US is back in deflation. Those pointing at prices, the CPI, and other such things do not understand what deflation is, nor do they understand what is important.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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