Understanding Chinese Policymaking
Traders do not think like government officials.
My traders friends would enthusiastically agree.
They are smarter, faster, and even better-looking!
It is fine for us to think that we are smarter and wiser than those making government decisions. Even if this is true, it may not help us when making predictions.
If we want to forecast the behavior of government, we need to take a different perspective. Most market commentators think about China from a trading perspective. Consider these two questions:
- Why does China continue to invest in US bonds? The interest rate is small. It is likely to rise leading to capital losses. The dollar, despite recent strength, is in a secular decline.
- Why would China invest in Italian bonds? They are risky. It seems like there are strikes every day. The CDS prices are rising. The market is screaming the risk.
The Trader Perspective
The trader, putting himself in the role of the Chinese, has an easy answer to both questions. The Chinese commitment to the US bond market is fragile and fleeting. They could sell at any moment. Who would then buy our bonds? It is yet another example of the danger of debt.
The Chinese would also be crazy to buy the bonds of Italy or any other European country. There are much safer investments and others that provide a better return.
The Policymaking Perspective
The trader view is far too narrow. On the first question it has been incorrect for many years. The Chinese are more interested in economic development, creating employment, and selling products than the profits on their bond portfolio. The US trade deficit is largely a function of the undervalued Chinese currency, an intentional policy on their part.
The Chinese also have a strong interest in worldwide economic strength and avoiding collapse in Europe. The consequences of cascading defaults might cost them much more than possible losses on a bond investment.
Conclusion
If you want to predict what governments will do, you must think like a government official. The trading perspective may be of little concern, a much lower priority.
The rumors of Chinese buying in Europe have been around for weeks. I did not mention them in my weekly update yesterday, because the story was too thin.
Now that the rumor has been published, it is worth evaluating. The outcome is far from certain, and I make no predictions here. The Chinese may get involved, but seek some other participants.
With this in mind, there are many parties with an interest in stabilizing Europe. This concept has been widely neglected by pundits who choose the sexy story: The death of the European Union and the related costs.
EU leaders may find the famous Mark Twain to be appropriate:
The reports of my death are greatly exaggerated.
If you traded 100% of your portfolio on the proven 100 day Nasdaq moving average method, you would have been out of the market in August to preserve wealth. Then you could get back into the market when the Nasdaq reaches the 100 day moving average again (with a fudge factor to avoid whipsawing). All the other ego speak marketing stuff is fluff to justify 96% of brokers never beating the market.
I do enjoy the intelligence of your fluff!
Jeff. I don’t buy the chinese as the savior in this case. They were supposed to be supporting Spain earlier this year but Spanish bonds still needed massive ECB buying in the last few weeks.
On the larger question of the risks in europe. I have argued for months that there are huge risks in europe that are not being captured by financial stress measures – such as the ST Louis Index.
I am still researching but one reason why that might be the case is because, as this article summarizes, there are new funding mechanisms being used by the most risky players, so funding stress may not be showing up in the components of the St Louis index.
http://ftalphaville.ft.com/blog/2011/09/14/677201/rise-of-the-pawn-swan/#comments
Angel — I’m sure you noted my statement about making no predictions. It is a funny thing about these rumors — they are best as sources of confirmation bias.
The SLFSI was not designed specifically for European issues. As far as I can see, it is doing a good job concerning the implications for US risk. The article you cite (and thanks for the pointer) suggests that US institutions are being pretty cautious with their collateral demands.
Thanks,
Jeff
Jeff – I believe that even a catastrophic meltdown in europe may have a lot less impact long term on the US market than many expect. S&P 500 company revenues from europe are only about 10%. The US financial companies have about 2 bil in cash on balance sheet so they won’t have the same funding issues they had in 2008. In that context the St Louis index may be doing a good job of measuring US systematic risk.
That said, a bad outcome from europe will drive the US market down, probably a lot.
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