In a brief news article, tucked neatly towards the bottom was one sentence with incredible global implications:

“The big drop in China’s holdings meant that it lost the top spot in terms of foreign ownership of U.S. Treasuries, dropping to second place behind Japan”

Chin ahas long been the largest holder of US Treasuries.  They are (were) our go-to group when we (the US) needed to raise some cash.  If the demand for our Treasuries from China drops off, that could lead to the US paying higher interest rates and a double dip recession for our economy.

It now appears that they are in fact reducing their holdings.  In fact, China has been reducing its exposure to US Treasuries for some time now.  While they are not out in the market selling them (that we know), they are trending towards purchasing shorter  duration notes.  This gives them a quicker “out” when the time comes.

When will that time be?  Well, that’s the $64,000 question.  If they were to dump their holdings onto the market at once, they would devalue the holdings they are trying to sell and do more harm to themselves than they care to.  If they become gradual sellers, they would damage the US economy and potentially we would not be able to buy as many Chinese made goods – again hurting their economy.

What China is doing is making every effort to create a burgeoning middle class that can replace the US as the consumer of their manufactured goods.  With 2 billion people to work with, that shouldn’t take too long to replace the 300 million or so US consumers.  Once that middle class is in place, China has much more freedom in their financial policy because they are not as tied to the US consumer.

This is one that will definitely take some time to play out, but it will play out and it will have dramatic consequences for our economy.

If that title doesn’t scare you then you might need to check your pulse…  Reuters ran an article this morning talking about how the US Federal Reserve couldn’t understand why the yield curve reached its steepest level in history last week.  Some of the theories it puts forth include, “the economy is recovering so well so there is less need for secure government backed investments”, “China may be repositioning its portfolio of treasuries”, and “the US economy is worsening and there might be a collapse of the US dollar”.  Some of these theories are in diametric opposition to each other, providing further indication that the Federal Reserve really isn’t sure of much.

I know I only have a college degree in economics, but let me give this a try…  We know the US Government is going to have to issue roughly $2 trillion of Treasuries to fund next year’s deficit.  That will push the Supply curve for treasuries out to the right.  We also know that the US economy continues to struggle, signs of improvement are few and far between and there is a very real prospect of inflation on the horizon.  That will shift the Demand curve in to the left.  What you are left with is reduced quantity demanded for Treasuries and a reduced price for Treasuries.  A general believe that this economic condition won’t last forever, and some change will be coming amplifies the effect the further out the yield curve you go.  A lower price means a higher yield and, voila, your yield curve is steepening.  I know this is a gross oversimplification of the Treasury market, but it at least gets you heading in the right direction.

In a further sign of the distress apparent in the bonds markets, the yield curve for US Treasuries moved to its steepest level in recorded history yesterday.  The spread between 2-year and 10-year notes breached 275 basis points.  The sharp increase in yields seems to be a result of concerns over the levels of debt the US government is incurring and how they will fund the spending.  According to a CNBC article,

With $2 trillion or more in issuance seen coming to market this year alone, some dealers were looking for a sharp readjustment in bond rates—which effectively reflect the cost to government of financing its borrowing.

The treasury did experience good demand for yesterday’s auction of $35 billion of 5-year notes.  However, strong demand for shorter term notes indicates a lack of demand for longer term issuance’s.  These are the ones that typically finance many of the municipal projects that provides the local services we, as taxpayers, demand.  In addition, the increase in longer term rates has a profound effect on mortgage rates, driving them up further.  This could serve to slow the improvements in the housing market, a sector which the US badly needs to improve in order to pull it from this recession.

While the debt markets may not be the most exciting thing to watch, they are extremely important to health and well being of our economy.