U.S. bonds still seem good bet for foreigners
(Los Angeles Times)
Updated: 2005-07-25 15:50

Wall Street pessimists seized on China's currency revaluation Thursday as signaling the start of a long and painful payback for America's spendthrift ways, inevitably leading to higher interest rates.

But by Friday, those worries already were dissipating — and Treasury bond yields that had spiked upward after China's announcement were falling again.

The 10-year T-note yield, a benchmark for mortgages, dropped to 4.22% on Friday from 4.27% on Thursday and was back to where it started the week.

For the last few years, bond investors have endured a constant barrage of warnings that the U.S. economy was becoming grossly overleveraged, owing to the nation's huge trade and budget deficits. Soaring borrowing by the Treasury was unsustainable, some analysts said, because so much of the debt was being purchased by foreign investors, particularly central banks in Asia.

Eventually, critics said, foreigners would stop being so willing to absorb U.S. debt. The result, they said, would be a jump in U.S. interest rates, popping the housing bubble and plunging the country into recession.

The sell-off in the Treasury market Thursday suggested that some investors saw China's move to stop pegging its currency to the dollar as a strong sign of a move away from dollar-denominated bonds.

But on Friday, many analysts contended that it still was a bad bet to think that Asian central banks and other foreign investors would simply stop buying U.S. debt. Such a move, experts said, would be self-destructive for those investors.

"It's not in China's interest to create financial instability given the amount of their assets," said Gerald Lucas, a bond strategist at Banc of America Securities.

About two-thirds of China's $711-billion trove of foreign-exchange reserves is in dollar-denominated securities, including Treasuries, government agency debt and corporate debt, Lucas said.

Of the total of $3.86 billion in U.S. Treasury debt held by private investors, $2.04 billion — more than 50% — is held by foreigners, government data show.

Because China's currency no longer is pegged solely to the dollar but to a basket of major currencies, China will need to rebalance its reserves by adding more bonds denominated in euros, yen and other currencies, Lucas said. That means its purchases of U.S. securities are likely to slow, but it doesn't imply a sell-off, he said.

Moreover, U.S. bond yields — even at levels that are low by historical standards — still are higher than those of slower-growing nations, including Germany, France and Japan.

China's currency shift came after years of U.S. complaints that the yuan's value was artificially low, giving Chinese exporters an unfair advantage over their American counterparts.

China's initial revaluation allowed the yuan to rise 2.1% against the dollar. Many analysts think that the yuan has further to rise, but that the Chinese central bank will allow only a very gradual increase.

If a sudden leap in the yuan's value caused U.S. consumers to back away from Chinese goods because of higher prices, "who's hurt worse?" asked James Bianco, head of financial research firm Bianco Research in Barrington, Ill. China has 50 million jobs dedicated to its U.S. trade, and rural Chinese continue to pour into manufacturing areas seeking work, he said.

Any appreciation in the yuan means that dollar-denominated bonds decline in value for the Chinese. But with China in a gradualist mode, its revaluation should have only modest effect on the Treasury market, Bianco said. He expected 10-year T-note yields to remain in the range of 3.8% to 4.6% that has prevailed for the last three years.

Even if China stopped buying U.S. securities, Japan's central bank probably would step in and defend the dollar to protect its own huge export trade with the United States, said Ralph Axel, government bond strategist at HSBC Securities in New York.

Peter D. Schiff, chief global strategist of Euro Pacific Capital, isn't so sanguine. Indeed, Schiff can fairly be called an alarmist on America's borrowing and spending ways. In a note to clients Thursday, he wrote that China's revaluation rang "the mother of all bells."

With the change in its currency regime, "the pressure on China to prop up the dollar will be greatly diminished," he said.

True, a weaker dollar would hurt Chinese exports to the United States, but over the long haul, a rising yuan would give ordinary Chinese the purchasing power to "enjoy the fruits of their own productivity," he said.

The flip side is a lowered American standard of living, Schiff predicted. A weaker dollar would mean higher prices for import-loving U.S. consumers, higher interest rates and a collapse of housing prices, he said.

Ray Dalio of Bridgewater Associates, which manages money for institutional investors, is less extreme in his language but said he generally agreed with Schiff.

He expects China and Japan to pare back their purchase of U.S. securities — not suddenly, but at a rate that would have a real effect by the end of 2006, he said.

"There's so much debt that it takes less of a rise in interest rates to shut off the economy," Dalio said.

(courtesy of the Los Angeles Times)

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