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China Caught Between the Dollar and a Hard Place


China can't allow its largest exporting partner to fall apart; government can't allow rates to rise.

Editor's Note: This is a conversation between Minyan P and Professor Fil Zucchi.

Minyan P:
Fil, realistically, how high can the 10-year rise from the 3.40% level? Looking at low rates in Japan (and now in the US), there seems to be a bigger force in control. It seems to me, traders don't have the courage to step aside and let rates rise.

China certainly isn't going to step aside and allow its largest exporting partner to fall apart. The government isn't going to stand by and allow rates to rise. There just seems to be a large collusion of groups keeping rates low. I'd like to see rates rise, as I believe it's unfair to prudent investors who are deprived of higher safe rates.

Fil Zucchi: I agree with you 100% that they'll do whatever it takes to keep rates low, and I'm now totally out of my long bond short. My point is that if the dollar falls apart -- and they cannot control that dynamic -- then rates will be jacked for them whether they like it or not.

And if they stand in front of it by monetizing Treasuries, it will actually exacerbate the
problem. So they're at the mercy of the dollar here, and the lower the dollar goes, the harder it makes it for them to prop up rates. If I were Ben Bernanke or Tim Geithner right now, I'd be going long Huggies, extra-absorbent in size.

Minyan P: Not sure if this makes sense, but some are arguing they want the dollar down to stimulate exports, and in fact, are behind this dollar devaluation. Why didn't they lose control of rates as the dollar dropped from 2004-2008? How did Japan keep rates near zero with "quantitative easing"? I'm not challenging your comments, but trying to understand why this go-around, the drop in the dollar would create a problem. Personally, I hope they get what they deserve for playing with Mother Nature!

Fil Zucchi: Yeah, that's a great point, and I'm not sure I've framed an answer in my head. Two main differences though, are: one, during that period I don't think we were being viewed as bankrupt yet, so people were buying our bonds and pushing rates lower as the "safety trade." Two, I think the currents of protectionism are rising to the surface - today's pissing match over steel being the latest.

And to add to that, I'm wondering whether China has as much an interest in buying our bonds, considering the money isn't being recycled into buying their exports, rather to fund our financial capital holes -- healthcare, education, union paybacks, etc. -- none of which would send the money back to China.
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