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U.S. Treasury Bubble

Written By Brian Hicks

Posted May 7, 2009

You may not realize this, but the biggest threat from China these days isn’t some old Red general bent on invading Taiwan.

Instead, the real dangers stem from an economic technocrat.

His name is Lou Jiwei, and in many ways he’s the most dangerous man in China — especially if you’re in the market for a mortgage.

That’s where the danger to Main Street comes in.

As the head of the China Investment Corp (CIC), it is Mr. Jiwei’s job to invest a portion of China’s growing supply of U.S. dollars. And with equities now in an uptrend, how Mr. Jiwei manages this mountain of money may well set the course of interest rates in the States for years to come.

That’s because if Mr. Jiwei is ultimately successful in building wealth through investments in equities and commodities, China will likely find low-yielding U.S. Treasuries much less attractive as the emerging giant works to diversify its national portfolio.

How China decides to invest those surplus dollars in the future will likely leave U.S. Treasuries hanging by a rather tenuous thread, since massive Chinese demand in the past is what helped to keep rates so low in the first place.

Of course, dangling right along with U.S. Treasuries will be the interest rates that consumers will have to pay in the future to finance everything from flat screen TVs to new homes.

Because as the air leaks out of the U.S. Treasury Bubble, interest rates will take the path of least resistance, which in this case is higher.

That’s an outcome that is even more likely now — especially since there will be a massive flood of new government borrowing meeting a market of slack demand. Treasury prices will fall as a result, pushing yields higher and bursting the bubble.

The U.S. Treasury Bubble: a Train Wreck Waiting to Happen

It is a simple fact not lost on many market watchers, including the "Oracle of Omaha" himself.

In his most recent annual report to Berkshire Hathaway shareholders, Warren Buffett was just the latest in a string of bubble-callers when it came to the ballooning price of U.S. Treasuries.

According to Warren:

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

Now, if that doesn’t sound like a train wreck waiting to happen, I don’t know what does.

After all, we all know how the housing and the bubbles came crashing down. Neither one of those is something I would like to repeat.

That may just be why the Chinese are suddenly so concerned about the future value of the mountain of U.S. debt they hold. They are the world’s largest holder of U.S. Treasury Bonds, and the value of those holdings will seriously decline as the bubble bursts.

"We have lent a huge amount of money to the U.S.," Chinese prime minister Wen Jiabao said last month. "Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried."  

And well he should be. 

China has the world’s largest foreign reserves, believed to be mostly in dollars, along with around 800 billion dollars in U.S. Treasury bonds, more than any other country. Some say that will only leave Mr. Jiwei with more money to manage as China becomes less willing to loan Uncle Sam the money he needs to deficit spend.

In fact, recent Treasury Department data shows that China may have already canceled Uncle Sam’s credit card earlier this year, as they sharply curtailed their purchases of bonds in January and February.

To fill the void, Uncle Sam will then need to turn to the Fed as his lender of last resort, creating inflationary pressures every step of the way. That combination is not necessarily bond friendly, giving the Chinese yet another reason to stop subsidizing lower bond yields through dollar recycling.

Higher Rates Are on the Way

That means after years of "historically low rates" in the low 5% range, future mortgage holders will be likely looking at more "normal" rates approaching 7%.

And while these higher rates may not alarm you, they will put even more pressure on home prices at time when the real-estate market can least afford it, since a 1% increase in interest rate decreases a buyer’s purchasing power by roughly 8%.

More than that, it also means refinancing just won’t be an option for more and more distressed mortgage holders in the future, causing more foreclosures as a result.

Meanwhile, yields have already started climbing higher despite the Fed’s efforts keep them lower. Yields on the benchmark 10-year note have jumped 45 basis points since April 15th, notching a 6-month high in the process. Moreover, 10-year note yields have broken resistance at 3% and look to be headed higher.

When they do, mortgage rates will rise with them. Only this time, we probably won’t be able to depend on the Chinese to keep them in check. 

As for Mr. Jiwei, he’s sort of like that flapping butterfly in China that can cause a tornado on the Great Plains. How he decides to invest China’s dollars could help to send U.S. Treasuries into their final act.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

Editor’s Note: For more on trading the downside of Treasuries, Ian Cooper’s Options Trading Pit has been trading them recently with gains exceeding 35%.  But, he says, there’s still time to buy puts and calls as Treasuries prepare to sink. To learn more about this opportunity, click here.