Chinese economist Fan Gang’s comments on China’s loss of faith in the U.S dollar was a rhetorical warning shot, probably in retribution to the gory budget numbers and to the Bush administration’s seemingly blasé position on the deficit.
"The U.S. dollar is no longer, in our opinion is no longer, (seen) as a stable currency and is devaluating all the time, and that's putting troubles all the time…So the real issue is how to change the regime from a U.S. dollar pegging to a more manageable reference, say euros, yen, dollars -- those kind of more diversified systems.''
When analyzing these statements one shouldn’t lose sight of the clear distinction between rhetoric and reality. Pulling the plug on America’s subsidy hurts both parties. China’s mercantilist motives of buying dollars (and thus U.S. bonds) to stroke their export base while concurrently assisting the U.S consumer who in turn buy Chinese goods is highly advantageous for Chinese growth. Limiting currency losses is simply not compelling enough to forego these benefits. I firmly believe that China would rather U.S authorities exercise fiscal restraint than to have the U.S suffer punitive damages through Chinese capital flight (or limited capital inflow).
But for those that believe the current U.S subsidy will continue indefinitely and that the bond market is therefore immune to a major sell-off – think again. Despite massive foreign capital inflow into the U.S Treasury market, we’ve had two substantial sell-offs in the past two years – one occurring in June 03 where yields rose 150 bps (the sharpest increase in yields since 1994, prompting a severe widening of credit spreads and a mini scare for those invested in GSE’s – Fannie Mae’s duration gap probs); and the other in March 04 where yields rose over 100 bps. So much for foreign central bank/private investor support given the extent of each sell-off.
Much has changed since the massive sell-off in 2003 including: higher inflationary pressures, a more restrictive monetary authority, a deteriorating budget outlook, a U.S economy even more dependent on foreign central bank intervention, etc. – all leaving the U.S bond market in a much more precarious position and thus more prone to an even larger bond market fall irrespective of FCB intervention.
Laying out the rationale for a major bond market fall is the easy part – timing it is more difficult, if not impossible. But if history is any guide, next Friday’s employment number (coupled with the Fed meeting) could provide the trigger as both sell-offs in 2003/4 commenced with a solid employment number.
--UK
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