Interest Rate Roundup

Wednesday, August 08, 2007

The bond market's China Syndrome

Bonds are having a rough go of it this morning, with long bond futures recently off 21/32 in price (and 10-year yields up about 6 basis points). What's up? For one thing, the stock market's post-Fed bounce from yesterday has carried over into pre-market trading today. More importantly, bonds are suffering due to some fear about the possibility of a financial "China Syndrome." The term refers to the actual meltdown of a nuclear reactor. The financial equivalent could be set off by China dumping its vast holdings of U.S. Treasury securities.

Why is this an issue today? In an overnight story in the Telegraph newspaper out of London, it was reported that the Chinese are making noises about dumping dollars and/or Treasuries in retaliation for U.S. pressure on China (over trade, the value of China's currency, the yuan, etc.). According to these U.S. government stats, China owned about $407 billion in U.S. Treasury debt as of May. That makes it the second-largest holder behind Japan (at $615 billion).

None of us should be as naïve as to expect China to dump a couple hundred billion dollars worth of U.S. bonds tomorrow. That would cause the value of its remaining bond reserves to plunge and U.S. interest rates to surge. That, in turn, would help drive a huge customer for Chinese goods – the U.S. – into recession. Instead, this is likely a case of China trying to put the U.S. on notice that strong anti-China trade legislation could be counterproductive.

That said, this news does appear to be hitting the dollar and Treasuries overnight. And it's likely that over the longer-term, less foreign buying of our bonds and other dollar-denominated assets will drive interest rates higher and the dollar lower.


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