I recently wrote about the debt bomb that has expanded in China
, and I am even more concerned about the credit situation in the region today. In a system choked with bad debts, we are seeing more loan defaults between banks, and perhaps most telling: the one-month SHIBOR (China’s interbank lending rate) has fluctuated wildly in recent weeks, climbing to 7.21%, skyrocketing to a record high of 13.44%, and then drifting back down to 8.1% -- an improvement, but still dramatically out of balance. Interbank Rates outside the banking system in China are even higher, and these peer-to-peer loan books continue to grow. They now represent more than $1 trillion in shadow lending.
This movement indicates extreme distrust among banks, and it is reminiscent of the interbank lending rates that signaled the eurozone crisis in 2011. Red flags abound, and China may have a harrowing journey ahead. The New York Times writes
that restructuring a slowing economy that has grown addicted to low interest rates and easy money could be perilous; the decision could tighten lending and slow growth too quickly.
This is all linked to interest rates here at home more than we might like. A credit shock in China would freeze foreign investment in the region and -- to ease that withdrawal from “easy money” -- would likely force China to fill the credit hole with capital infusions. As Reuters noted
in mid-June, the run-up in foreign reserves was designed to guard against painful stops or gaps in foreign financing, and it may come into play sooner than hoped. “Any rundown of currency reserves may also require the sale of Treasuries, potentially steepening the rise in long-term US interest rates, boosting the dollar and compounding the shock.”
That’s when the impact starts to drift to our shores. China is the largest outside holder of US Treasuries, with $1.6 trillion in US bonds on hand. When they become a seller, rates are likely to be squeezed upward whether or not there is inflation driving the momentum.
Exacerbating the situation, there is word that the Fed may begin “tapering” back their $85 billion-per-month bond-buying program. The rumors produced sudden turbulence in many markets that had been defying gravity on airfoils of emergency low rates in the US. The 10-year US Treasury rate moved from 1.63% to over 2.2% in just over a month, a massive change that was seen as a shot across the bow, sparking a dramatic sell off of high-yield and defensive investments in May.
In reality, the jump in rates should not have been a surprise. It is true that prognosticators have projected a long runway for maximized Fed operations, as inflation seems well-contained... but we don’t need an inflationary spike to drive rates higher. A normalization of rates from these extraordinary lows is likely enough as developed market economies show stability (even without exciting growth), and there are many factors that can contribute to a rate lift outside of the Fed’s control.
I am not a market timer, but with all this in mind, I suspect that we are very close to having rates reset to more normalized levels, moving the 10-year to somewhere in the 3% to 4% range. For those who have crowded into long bonds, junk bonds, utilities, and other expensive, slower growth investments to chase yield against the specter of Japanese-style deflation, I believe that you are in harm’s way.
On the other side, for those who see a rise in interest rates only as an indicator of inevitable inflation and have invested in commodities and TIPs as insurance, I believe these insurance policies are likely to become more costly and that they are vulnerable to non-inflationary interest rate normalization and a potentially stronger dollar.
The truth very likely lies somewhere in the middle of these two binary extremes. We may need to muddle through continued slow and uncoordinated global growth for longer than many expect. Investors should remain focused on balance sheet as the ultimate insurance in a deleveraging world and on finding growth and innovation where it exists today. I favor smart manufacturing plays, innovations in health care and technology, and leaders in energy efficiency; those who uncover strong companies in these sectors are positioned to gain more than those who place all of their bets on the direction of government policy or on insurance against the fat tail extremes.
No positions in stocks mentioned.