Wednesday, March 11, 2009

Most important theme - the loss of our imbalance friends

The trade balance in China moved from a very strong positive number to almost flat with both exports and imports decreasing 25%. This is after the announcement that the Japanese current account balance turned negative.

These two countries have been the two largest buyers of US Treasuries as they recycled their trade surpluses back to US dollars. They financed the US consumer purchases, but now will not be in the market. The rest of the world or the US investor will have to be the buyer of Treasuries, but this is not sustainable at current rates.

First, while US consumers have increased savings and there has been active buying of Treasuries as a flight to quality trade, this may not continue. If the credit crisis is slowed, there will be a movement out of safe assets and into riskier assets which means that the demand for Treasuries will decrease. Second, as long as the rest of the world is in recession, there may not be enough money to invest in Treasuries.

The ramifications are significant. The bond vigilante are back and Obama is going to have to listen. How can you lower mortgage rates if the Treasuries are crowding out the markets and causing a general increase in yields. Monetize everything?

The market knows this. We have seen 10-year yields move from 2.08 to to 2.99 in about 2 and a half months. The 5-year has moved from 1.26 to 1.99 over the same time. Fixed income may be more important than following equity markets.

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