The answers to two looming questions are becoming clearer: Why have interest rates fallen? And is China actively trying to rid itself of exposure to the dollar?
Below is a chart of the yield on the 10-Year Treasury Note. After starting the year near 3%, yields have continuously fallen through 2014 and now sit near 2.5%. This move was unexpected for a number of reasons, and many investors took this as an ominous sign from the bond market. Interest rates often decline during periods of economic weakness, and the declining rate environment has caused a cloud of worry to engulf the markets.
It's also been puzzling how interest rates could fall at a time when the Federal Reserve is systematically removing itself as the major buyer of Treasuries. As it turns out, the Fed may have China to thank for providing a clean exit.
Recent data shows that in 2014, China has been purchasing Treasuries at the fastest rate in over three decades, since record keeping began. As the Fed scales back its bond purchase program, China has ramped up, purchasing over 0 billion worth of Treasury debt during the first five months of 2014 (see chart below). The net effect has pushed bond prices higher, resulting in lower yields.
h/t: SoberLook
The timing seems almost too good to be true. After a Chinese agency downgraded U.S. government debt late last year, China is now buying at the quickest pace on record? Two explanations are being thrown around: First, there just isn't a deep enough global debt market to satisfy China's demand without U.S. debt. Second, by purchasing dollar denominated debt, China is placing downward pressure on the Yuan, which helps Chinese exporters.
I talk to a lot of investors who are worried about a financial shock caused by China dumping U.S. Treasuries. This is not something that we can ever rule out, but I usually urge them to consider the fact that China is heavily incentivized against behaving that way. It would cause the yuan to rise, which would depress Chinese growth at a time when growth worries already exist. And China has such a large investment in dollar denominated assets, they would be shooting themselves in the foot.
But regardless, declining U.S. yields continue to be a drag for income investors, putting pressure on already strapped retirees and savers. If there is a silver lining, it's that lower interest rates are aiding an already weakening housing market.
The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
