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Great Unwinding of policymaker stimulus creates interest rate risk

By Paul Hodges on 10-Sep-2014

US int rates Sept14Interest rate risk is rising in the developed economies as the Great Unwinding of policymaker stimulus continues.  Since the blog first highlighted this Unwinding last month:

  • Oil prices have continued to tumble, with Brent now down over $15/bbl from its late-June peak
  • The US$ has continued to rise from multi-year lows versus the yen, euro and pound

And of course, these developments are self-reinforcing.  Pension funds are now losing money on their oil market positions.  They also have no reason to own oil as a ‘store of value’ if the US$ is strengthening.

In turn, these developments also impact interest rates and equity markets.  The blog looks at interest rates today, and will then complete its mini-series next week by focusing on equities.  As the chart shows:

  • The US 10-year bond fell last year, as US investors believed economic recovery had become certain
  • In turn, this caused interest rates to rise, as bond prices are the inverse of interest rates
  • But more recently, the downward trend has halted, much to the surprise of the ‘experts
  • The 10-year Treasury bond has thus been trading in a narrow band this year (blue lines)

This confirms it has been China’s reversal of economic policy that has changed financial market direction.  US Federal Reserve cutbacks have been relatively minor by comparison.  As the blog warned in February, when publishing its major Research Note (China bank lending: From $1tn to $10tn and back again).

Why did nobody notice that China was the ‘elephant in the room’, in terms of being the main cause of today’s downturn in global demand and financial markets?”  Answer: “Because we were all wearing rose-tinted glasses”.”

The question today is what happens if China’s housing bubble continues to burst?

  • 49 million homes in China’s urban areas have been sold to speculators and sit empty today – more than 1 in 5 of the total – and $674bn of mortgage loans are secured on them
  • Financing for the bubble has mainly come from Asian investors and the shadow banking system, so lenders to both these sectors will face big losses
  • It will also undermine the ‘collateral trade’, so large quantities of iron ore, copper and even polymers will flood global markets in a disorderly fashion
  • Most likely therefore, this will put further pressure on oil prices and strengthen the US$, reinforcing current trends
  • But it will also focus attention on the key issue of debt repayment (as well as the outlook for company earnings)

We cannot know how markets will react:

  • They might decide to see US markets as a ‘safe haven’ and dump debt in weaker currencies, such as the yen, euro and pound.  If this happened, US interest rates could fall sharply
  • Alternatively, investors might be forced to raise cash quickly to meet margin calls*, if commodity markets start to dive.  This could force them to sell low-risk assets such as US Treasuries, causing interest rates to rise

This is one of the reasons why the blog fears we may see scary moments as markets slowly recover their prime function of price discovery.  The collapse of the Chinese housing bubble will not just impact China – in fact, its biggest impact may well be felt outside China.

The reason is that, as the blog suggested back in June, China’s earthquake will open fault-lines in today’s debt-fuelled global ‘ring of fire’


*Margin debt is at record levels in New York markets, so this might be the only way to meet ‘margin calls’ (these are brokers’ demands to make immediate payment if prices have fallen during the day).