Warning: China propping up their economy by “selling” U.S. Treasuries

"The Fed doesn’t fully understand the market volatility that stemmed from China’s shift in its foreign exchange regime" commented Fischer in a media interview in Jackson Hole, Wyoming.   (See CBS MarketWatch, August 28, 2015)  Even the U.S. Federal Reserve  isn't clear (or willing to share) what is really going on, so investors may want to get the facts for themselves.

The knee jerk reaction in the media that the Chinese were devaluing the Yuan on purpose shows how shallow U.S. reporting on financial markets has become.  The facts are that there is a capital flight out of China that has been putting severe downward pressure on the Yuan.

The Chinese did not “devalue”, which implies they are playing the typical mercantile economic game of manipulating their currency downward against the dollar to improve trade by "buying" U.S. Treasuries.  To the contrary, the Chinese had to "sell" $100B in U.S. Treasuries (See Bloomberg News, August 27, 2015) just to maintain the peg they have set against the U.S. dollar for the Yuan in order to support their own their own declining economy.

What this means to the Fed is that financing the U.S. debt has just reached a tipping point.  What China did by selling $100B U.S. Treasuries will have the same effect as the FED buying Treasuries.  It floods the market with more dollars.  The problem in this instance is that the FED now faces the real possibility that it might be the only buyer left that wants U.S. Treasury paper if this trend continues.  Raising rates is very likely to become the only means the Fed has to support the huge financing appetite of the U.S. government since the supply chain from emerging market mercantile economies like China and petrodollar fixed income supplies from Saudi Arabia are beginning to dry up.

Financial Relativity Index Warns Investors to Reduce U.S. Equity Exposure

Anyone who follows the Financial Market Vigilante blog and has read my book, Theory of Financial Relativity, knows that my research looks at the U.S. financial markets systematically.  By looking back through time to gain an understanding of how key market metrics performed during boom and bust cycles, I have developed a heuristic model which investors can use to gauge whether key fundamental forces are strong enough to sustain current stock market index price levels.  The model is simple.  It contains 7 market variables that are tracked through time.  As specific market thresholds are breached, the risk of a DOW (DIA) or S&P500 (SPY) market downturn increases.  The model uses quantitative metrics (and one qualitative).

To illustrate the stability in the relative value of the market at any particular time, the index variables (shown in the graph below) are illustrated using green, yellow and red markers.  Green is considered the neutral or low probability zone for the metric to create a condition conducive to a major market correction.  Likewise, a yellow marker denotes a cautionary condition, and red denotes a relative measure that has a high probability of causing downward market pressure.  Through time as the measurements change, the directional change in each variable is also assessed and if a variable is approaching, but not yet reached a warning condition, then it is outlined in red.

At the beginning of 2015 my commentary on the state of the U.S. equity market based on the Financial Relativity Index was the following:

“The financial metrics as 2015 begins are increasingly cautious, as exhibited by the number of yellow and red markers. The model over the past two years has become progressively more “colorful.”, another way of saying the trend is not your friend at the present time. Based on the research I have done in each categorical area, I expect more of the metrics to reach a red level before the stock market is likely to undergo a sustained severe downturn. The increased areas of caution in many of the metrics, however, set 2015 up in my opinion to be a very volatile year for equity values, with a likelihood of a major intra-year drop at some point.”  - Blog Post, January 10, 2015

The metrics referred to in the statement are shown in the table below, and augmented by the status of the metrics as of the end of July, 2015.  The July month end metrics, which were updated on the Financial Relativity.com website after the July close, included a warning statement for the first time.  The warning was “Deflation Driven Correction Risk Extreme”.

The movement in the metrics since year end 2014 led to the need to post the warning.  In particular, the index metrics that have worsened since the first of the year are: 

1.  GDP / Lending Risk - the continued increase risk in U.S. credit markets as loan balances grow to all-time highs relative to the size of US GDP.
2.  BAA1 / 30 Year Treasury Spread - a major widening of spreads between the Treasury market and investment grade bonds to historical warning levels.
3. Fiscal Spending Rate - stagnant U.S. fiscal spending yearly growth continues below historical levels and slowed to -0.1% in Q2 2015.
4. Oil Price Levels - rapid commodity price deflation as exhibited in the oil market creates a warning sign on what should be a positive for U.S. consumers.
5. Fed Policy - the tightening of monetary policy relative to the world because other countries are devaluing their currencies relative to the U.S. dollar.

All these metrics became progressively stronger headwinds as the stock market pushed to higher and higher all-time highs during the first half of 2015.  The fact that Apple (AAPL), the bell weather in the current tech driven bull market, suddenly lost its appeal in the market and recently entered correction territory was a good anecdotal signal that the overall market was entering a correction phase.  The stock market relative to GDP (DOW:GDP) has been expensive for over a year, and is now in progress of rolling-over.  The recent market pull-back has left the metric in caution territory, but since the momentum in stock price growth is now negative, risk is still high for further declines.

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