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China: Lowest U.S. Treasury Holdings Since Early 2010

Chinese holdings of U.S. Treasuries continued to plunge in the month of November.   There was a sharp $200B drop in the second half of last year, market participants have been waiting to see what Beijing did after the Trump election.  The answer?  Sell.

A Cool $66B Sale

China‘s U.S. Treasury Securities Holdings fell to $1.049 trillion in November from $1.116 trillion in October. Much of the vicious sell off in bonds through the month of November was thought to be due to the “reflationary trade” environment.   Wall St.’s been pricing in a Trump administration running up deficits and more pro-growth legislation coming out of Washington. 

The world’s second-largest economy uses its foreign-exchange reserves to support the yuan:

The narrative plays well in the press, but in reality a lot of the selling is pointed at the Chinese raising emergency cash. Since June of 2016, the Chinese have been aggressively selling U.S. Treasuries in order to raise cash and defend their currency, the yuan. This has been a huge catalyst for the bond sell off in Q4 2016.

Since April, the currency (yuan) has devalued by 8% through December 2016, as cash has been pouring out of the country.  China has spent billions trying to prop the currency up, defend her.

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U.S. Treasury data show the country has dumped about $270 billion of U.S. government debt since its holdings peaked at $1.32 trillion in 2013 and is using the funds to underpin the yuan and stem capital outflows.

The question is, does it make sense for China to keep selling treasuries at such a fast level? We think not. By selling treasuries, the Chinese are only sending yields higher in the U.S. which supports a stronger Dollar, something the Chinese cannot afford. A big question for 2017 will be, do the Chinese continue selling off treasuries, or does the fear of further depleting reserves and raising the Dollar put them off.  Pick up our latest report, just click on the link below.

Foreign holdings of U.S. Treasury debt totaled $5.9 trillion, a drop of $96.1 billion from the previous month. That was the lowest since 2014.

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Where are bond yields going with risk of a euro breakup on the rise?  Click here (above) for our latest report.

In today’s moving speech, Mrs. May stressed Britain’s determination to regain control of migration from the European Union and rejected the supremacy of the European Court of Justice, even at the risk of losing unfettered access to the single market and its nearly 500 million consumers.

U.S. Bond Rally Continues

Just when Wall St. told you to “get out of bonds” we’ve experienced one of the most significant rallies in recent years.  As bond prices rise, yields move lower, 32bps in 24 days is impressive indeed.  The weaker Dollar, stronger Pound is helping today.

“Let me be clear,” said Mrs. May, adding that any agreement would be sent to both houses of Parliament for approval. “What I am proposing cannot mean remaining in the single market.”

*MAY SAYS GOVT WILL PUT FINAL BREXIT DEAL TO VOTE IN PARLIAMENT
*U.K.’s May Says She Wants a New Deal With EU Customs Union

“I do not want us to be bound by the common external tariff… I do want us to have a customs agreement with the EU.”

“I want to be clear, what I am proposing cannot mean membership of the single market. European leaders have said many times membership means accepting the four principles” of the EU.

Theresa May’s speech is moving markets as expected.   It’s important to note, Parliament will be voting on the terms of the Brexit, life after Brexit. 

May’s Goals:

Wants Customs Agreement With EU
May Need to Be Associate Member of Customs Agreement
Open to Options on New Customs Union Arrangement

Prime Minister Theresa May on Tuesday set a course facing a clean break with the European Union after more than four decades of integration with the Continent.

Too Many Shorts?

Positioning in the Pound has been one sided for much of the last 6 months. Considering this, speculators have seemingly done a bit of short covering on the back of the news that the British Parliament will have a final say. Today’s rally is looking a like a sell the rumor buy the news event, as the Pound has become very politically driven.

The U.K. parliament will get a vote on the final Brexit deal before it is implemented, Prime Minister Theresa May said, as she tried to offer business some certainty about its future.  Bears have been driving the pound heading into May’s speech, cover (shorts) on the news is in play today.

“The United Kingdom is leaving the European Union, and my job is to get the right deal for Britain as we do,”

May says four key principles guide her Brexit goals. They are:

Certainty and clarity
A stronger Britain
A fairer Britain
A truly global Britain

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Newsletter writers in the “bullish” camp according to Investors Intelligence fell to 58.6% from 60.2%, this broke an 8-week string of gains which began at 41.7% in early November.

A BIG however, Bullish sentiment remains above 55%, clearly in the “danger zone” for a market roll over.  In 2014,15 and 16 investors were far better off holding cash levels high in January and putting money to work once fear returned to markets in the middle of the year.  We are in this camp for 2017.

Pick up our Trade Alert Recap Here

We were Buyers of Stocks in February and June, Fear was Value in 2016

The last time there were this few bears, U.S. equities plunged nearly 13%.  We advised our clients to buy stocks aggressively in February (click the link below, we’ll send you the reports) and June of last year, today the risk – reward is NOT attractive in owning stocks.  Bears slipped to lowest since Aug. 2015 to 18.3% vs 18.4% last week Correction rises to 7-week high 23.1% from 21.4%.   The bottom line, those who beat the market in recent years were buying stocks while others were running away from them.  As you can see above, as the bears in peaked in February, stocks bottomed. 

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Where are bond yields going with risk of a euro breakup on the rise?  Click here (above) for our latest report.

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Where are bond yields going with risk of a euro breakup on the rise?  Click here (above) for our latest report.

The Group of Seven (G7) refers to the group of seven highly industrialized nations—France, Germany, Italy, the United Kingdom, Japan, the United States and Canada.  As we turn the page to 2017, there are only two of these leaders (below) left in power.   A bright sunny day has been overcome by global populist rage, there’s more to come.

Heading towards September’s German elections, we believe Merkel’s CDU party will come under populism’s sword.  Last summer, we had our clients prepared for a Trump victory, now we’re focused on Europe’s crowded 2017 Election cycle (Netherlands, France, Italy and Germany).

And then there were Two

This picture was taken early last year, and all that’s left are Shinzo Abe and Angela Merkel.  Political risk has been driving equity prices globally, and this is where we shine.  The populist tsunami sweeping the globe has more victims in 2017, we must get out in front of the winners and losers.

Bonds, Italy vs Germany

One way we measure risk in equities is by meticulously monitoring “credit spread contagion.”  Bond markets typically are out in front of many black swans, as you can see above the yield spread between Italian and German government bonds has been widening sharply in recent months, this speaks to rising Euro breakup risk.

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Euro and Breakup Risk

Eurostoxx 600 are up 20% since the Brexit, but a dovish ECB in the middle of QE (government bond buying program), as well as rising Euro breakup risk have the currency (above) through support and at multi year lows.

Bonds, Portugal vs. Germany

Portugal’s debt to GDP ratio has surged from 50 to 131% since the creation of the Euro, its economy is not growing fast enough to support an aging population and colossal government largess.  Similar to Greece, labor unions have been promised unsustainable goodies from politicians.  This practice has longer legs when a government can print money to buy votes, but the Euro is clearly killing Portugal.  As you can see above, even though the ECB’s Mario Draghi has promised to do “what ever it takes,” as we head toward the German elections, bond holders are nervously selling Portugal’s debt.  As we kickoff 2017, credit spread contagion is taking bond yields higher throughout Europe’s periphery, something we witnessed in 2011-2.  Back then, eventually U.S. equities were caught up in EU credit risk.

Pick up our latest report below:

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“I was born at night, just NOT last night.”

George Carlin

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Where are bond yields going with debt on the rise in China?  Click here (above) for our latest report.

Sunday Night, January 8, 2017

• China Weakens Yuan Fixing by 0.9%, Most Since June 2016
• PBOC set yuan fixing at 6.9262 vs USD, 0.87% weaker than Friday
• China’s currency is 15% overvalued in our view
• Damage Control: The People’s Bank of China will inject 10b yuan into the banking system using 7-day reverse repurchase agreements today
• The central bank will also inject 100b yuan using 28-day reverse repos

Breaking News: China’s foreign currency holdings remained above $3 trillion in December even as the yuan capped its steepest annual decline in more than two decades.

Better fiction than Harry Potter, China’s foreign exchange reserves fell $41.08 billion to $3.01 trillion, the People’s Bank of China (PBOC) said in a statement Saturday. That matched a $3.01 trillion estimate in a Bloomberg survey of economists.

The PBOC is running out of options with FX reserves getting quite low. Of course, as a headline number their FX reserves are high, but as we have stressed to clients, as percentage of the money supply (M2) they are quite low.

“This week, we do not believe the PBOC will let reserves drop below the psychologically important level of $3 trillion.”

The Bear Traps Report,  January 4, 2017

In an effort to prevent a global panic within the investment community, China is using emergency measures to keep its foreign-currency stockpile from slipping too far below the key $3 trillion.

We believe as even more confidence is lost, further declines in the yuan will follow. Policy makers in China have recently rolled out extra requirements for citizens converting yuan into other currencies after the annual $50,000 quota for individuals reset Jan. 1, more emergency currency controls to come.

China wants the upside of capitalism without the downside of dealing with a loss of investor confidence, but you can’t be a little bit pregnant.

The Hemorrhage Continues

Capital is running, NOT walking out of China.  As was the case in Q1 2016, China is the big story to watch. As the Yuan gets closer to 7 against the U.S. Dollar, we believe the Chinese are at an inflection point. The PBOC (Peoples Bank of China) tried to get the currency under control by aggressively selling ($200B) U.S. Treasuries in the back half of 2016. However, this led yields higher and made the Dollar stronger and ended up hurting China’s FX position.  In our view, there’s over $1T of losses in China’s highly levered, Lehman like black box, yes their banking system.  Bottom line: $3T of currency reserves doesn’t go as far as it used to with a Swiss cheese banking system bleeding cash.

China’s recent policy of opening its markets to foreigners is expected to continue this year, but there are questions about how meaningful the change will be amid a clampdown on money leaving the country.

Damage

As China loosened controls on its interbank bond market and relaxed rules for offshore investors trading stocks.  It also saw nearly $800B head overseas in the first 11 months of last year, according to Bloomberg estimates.  Investors sought safety in foreign assets pushing the yuan down 6.6% against the dollar in 2016, the most since 1994.

2006-2016 China Leverage

Credit Growth: 1175%
GDP Growth: 470%

The Bear Traps Report data

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China Corporate Debt to GDP vs Federal Reserve’s Balance Sheet

2016: 165% vs $4.5T
2008: 105% vs $700b

Bloomberg, the Bear Traps Report

The Fed’s been the Great Enabler

Has the Fed’s easy money gravy train found in zero interest rate policy been China’s great enabler?  You bet it has.

China Debt Issuers

% with Negative Credit Rating Outlook

2016: 70%
2015: 29%
2014: 15%
2013: 14%

Moody’s

The Great Shell Game

Again, Chinese devaluation risk will be back at the forefront in 2017.
Another important theme; Chinese capital flows are having a
massive impact on asset classes around the world.  As cash pours out of the country the spread between the off shore yuan (CNH) and on shore (CNY) widens.  In an effort to control the beast in the market, China from time to time steps in and strengthens their currency, as you can see above they made a substantial “panic” move last week in an effort to stop the bleeding.

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We’re just back from Moscow, join our Larry McDonald on CNBC’s Closing Bell today at 3:10pm.

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Russian Ruble has been the Top Preforming Emerging Market Currency in Q4 2016 

Republican Donald Trump won U.S. elections on Nov. 8 with a promise to improve ties with Russia, holding out the possibility of easing sanctions imposed after Moscow’s 2014 annexation of Crimea from Ukraine.   The ruble has been the big winner, dramatic outperformance. 

We visited Russia (Moscow) this month.  Russians are very excited about the prospects of the incoming Trump administration.  The 70 year relationship between NATO – USA – Saudi Arabia is coming to an end, Russia will be the big winner.

Big catalyst for Russian equity’s in 2017 will be rate cuts as inflation has finally gotten under control this year. Real rates are far too high and will come down.  Russia’s bonds are attractive as well, falling inflation will bring 150-200 basis points in official interest rate cuts next year. That will keep inflation-adjusted bond yields at among the highest in the world.

RSX (equities) are still 63% off their 2008 highs.  Inflows in December are the best in three years.

Click below for our full report:

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Over the last week U.S. financial media went on a typical “scare and click” campaign against President-elect Donald Trump’s foreign trade counsel, led by University of California Irvine professor Peter Navarro.  Over the last 15 months its now very clear media outlets have used drama and scare tactics in an effort to drive traffic to their websites.  Donald Trump has been a savior in terms of giving many financially strapped media players a boogieman to throw around, in an effort to collect eyeballs of course.

“This is a negative trade message, and we should be concerned” as the appointment will disturb China-U.S. trade relations, said He Weiwen, deputy director of the Beijing-based Center for China and Globalization.  “If there’s a trade war breaking out between China and the U.S., both would be affected, but the U.S. side would lose more.”  Bloomberg reported Weiwen’s comments.

“Trump’s tariffs will make almost everything more expensive — and maybe cost you your job.”

Money.Mic’s Emily Singer

US Personal Consumption Expenditure Core Price Index YoY

With the exception of March 2012, core PCE inflation has not been above 2% since September 2008.  The Fed sees core PCE greater than 2% as early as a year from now.  As you can see above, secular stagnation has placed core PCE inflation is a multi year secular down trend.  As we head towards a Trump Presidency, markets are pricing in aggressive trade tariffs fired at China.  Cheap goods imported into the USA have been a benefit to the U.S. consumer, but a detriment to the U.S. manufacturing base.  Any interruption in terms of trade tariffs will result in higher prices of goods.

U.S. Treasuries’ Yield vs. Inflation Expectations

U.S. 5yr 5yr Forward Breakeven vs the 10 Year Bond Yield

There are many methods of varying complexity that investors and policymakers use to estimate the level of expected inflation, but one relatively straightforward method is to examine the “breakeven” inflation rate which is the difference in interest rates between Treasuries and TIPS.  This method has the advantage of being determined by market prices, so it reflects the views of investors who have money on the line.

The Road Ahead

“Trump will impose countervailing tariffs not just on China, but on any American trade partner that cheats on its trade deals using practices such as currency manipulation and illegal export subsidies. Such tariffs are not protectionist but rather defensive — and consistent with actions taken by American presidents from George Washington to Ronald Reagan. Indeed, one of the first bills Washington signed was a tariff, which Alexander Hamilton justified as a necessary defense against a mercantilist Europe.”

Peter Navarro, 2016

A recently released study written by Wilbur Ross and Peter Navarro dives into the underlying issues behind secular stagnation.  The assumed, incoming protectionist trade stance of the Trump administration has been well advertised.  Negative press coverage of Trump’s potential trade policies out numbers positive  8-1, a review by the Bear Traps Report shows.  In our view, the media is far too focused on trade tail risk, and not enough focused on trade deal upside for the U.S. economy.  In reality, why does a shot (40% trade tariff) actually have to be fired?  The meltdown trade scenario has been well advertised by CNN, MSNBC and the Huffington Post.

China’s economy is in its 7th year of lower year over year GDP contraction.   Their banking system is the most highly leveraged on earth, they are in no position to take big trade risks.  They likely do a deal.

China Trade

A leading economist with a doctorate from Harvard, Navarro has spent much of his career criticizing China. Over a career of more than two decades, he has written books and directed a documentary on the U.S.-China trade relationship that helped form the backbone of the Trump campaign message on a pivotal election issue that played to globalization fears.

“export licenses had formerly been more difficult to obtain in some industries than others, their removal may have led to a surge in Chinese exports and subsequent decline in U.S. manufacturing employment in the industries where licensing was most binding.”

Ross – Navarro, 2016

Secular stagnation is a condition of negligible or no economic growth in a market-based economy. When per capita income stays at relatively high levels,  the percentage of savings is likely to start exceeding the percentage of longer-term investments in, for example, infrastructure and education, that are necessary to sustain future economic growth. The absence of such investments (and consequently of the economic growth) leads to declining levels of per capita income (and consequently of per capita savings). With the reduced percentage savings rate converging with the reduced investment rate, economic growth comes to a standstill – ie, it stagnates. In a free economy, consumers anticipating secular stagnation, might transfer their savings to more attractive-looking foreign countries. This would lead to a devaluation of their domestic currency, which would potentially boost their exports, assuming that the country did have goods or services that could be exported.

Persistent low growth, especially in Europe, has been attributed by some to secular stagnation initiated by stronger European economies, such as Germany, in the past few years.

Ross and Navarro are quite explicit in their introduction that  trade deficits have been a critical inhibiter of economic growth.  Simply states, key contributor to GDP has been the lag in net exports.  Another element is that he uses trade deficit reduction and trade policy reforms is for the revenue offset of substantial tax cuts. As a whole we found the paper to be EXTREMELY trade hawkish, a firm defensive trade position is coming to the White House.

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Secular Stagnation

GDP in Decline since the Late 70s

U.S. nominal GDP is in a long term secular decline, the Trump administration hopes to reverse the impact of secular stagnation.

“There is nothing inevitable about poorly negotiated trade deals, over-regulation, and an excessive tax burden – this is a politician-made malaise. Therefore, nothing about the “new normal” is permanent. ”

Ross – Navarro, 2016

The New Normal

Ross and Navarro point out, from 1947 to 2001, the nominal US gross domestic product (GDP) grew at an annual, rate of 3.5% a year.  However, from 2002 to today, that average has fallen to 1.9%.  This loss of 1.6% real GDP growth points annually represents a 45% reduction of the US growth rate from its historic, pre-2002 norm. Just why did the US growth rate fall so dramatically?

Over the last eight years, the U.S. didn’t achieve one year of year over year +3% growth.  That has not happened in nearly 100 years.

U.S. Real Year over Year Annual GDP

2016: 1.9%
2015: 2.6%
2014: 2.4%
2013: 1.7%
2012: 2.2%
2011: 1.6%
2010: 2.5%
2009: -2.8%
2008: -0.3%
2007: 1.8%
2006: 2.7%
2005: 3.3%
2004: 3.8%
2003: 2.8%
2002: 1.8%
2001: 1.0%
2000: 4.1%
1999: 4.7%
1998: 4.5%
1997: 4.5%
1996: 3.8%
1995: 2.7%
1994: 4.0%
1993: 2.7%
1992: 3.6%

• Above 3% year over year growth is in blue

Bloomberg, CBO data

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Many left-of-center economists – and the Obama Administration – have described this era of slower growth as the “new normal.” They blame this plunge at least in part on demographic shifts such as a declining labor force participation rate and the movement of “baby boomers” into retirement. This view of America’s economic malaise is incomplete – and unnecessarily defeatist. It ignores the significant roles higher taxes and increased regulation have played in inhibiting US economic growth since the turn of the 21st century as well as our ability to fix the problems.

As a % of GDP, the U.S. trade deficit is still in a long term secular down trend.

This new normal argument also ignores the self-inflicted negative impacts from poorly negotiated trade deals and the failure to enforce them. One need look no further than the lengthy list of transgressions detailed in the National Trade Estimate for examples. These bad deals include most notably NAFTA, China’s entry into the World Trade Organization in 2001 – a critical catalyst for America’s slow growth plunge – and most recently Hillary Clinton’s debilitating 2012 South Korea trade deal.

To view the rest of this report, trade winners and losers in 2017, click here:

 

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