IN-DEPTH: TRANSCRIPTION - UnderTheLens - 04-24-24 - MAY – Yellen’s China Showdown
SLIDE DECK
TRANSCRIPTION
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Thank you for joining me. I'm Gord Long.
A REMINDER BEFORE WE BEGIN: DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are COMMENTARY for educational and discussions purposes ONLY.
Always consult a professional financial advisor before making any investment decisions.
SLIDE 3 - COVER
Sino-American relations continue to deteriorate despite both realizing they need each other more than ever. In that context China and the US are trying to achieve a working dialogue that would be mutually beneficial, unfortunately, it seems any progress is trumped by another escalating point of conflict.
The simple reality is both are moving forward on different paths which will only accelerate the divergences. I want to talk about those paths in this session and how they are at odds with each other.
SLIDE 4 – AGENDA
In attempts to stabilize the situation after prior visits or meetings by Secretary of Commerce Gina Raimondo, Secretary of State Anthony Blinken, Secretary of the Treasury Janet Yellen along with US Senate and Congressional Committee members it came down to Janet Yellen arriving in Beijing for a no holds barred session.
The diverging paths forward and the purpose of Yellen’s trip is the focus of this video. As such I want to discuss the areas outlined here.
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The billing for Yellen’s trip was purely optics and Doomed-to-Failure in that regard before she left.
The rushed trip by Janet Yellen to meet with her Chinese counter-parts was billed to improve Sino-America relations. Festering, unresolved issues have been steadily deteriorating on multiple fronts, but her trip was touted to be focused on Trade Relations. We disagree I will talk more about what the trip was really all about!
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The Chinese have been pointedly clear that the US is the problem and there is little reason for wasted talks of the subject. A meeting seeking China to change its trade policies was simply not going to result in that occurring?
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The US political optics therefore was to demonstrate to the US electorate that the Biden Administration was doing everything it could to achieve a working Trade relationship with China, before the inevitable collision resulting in much broadening Tariffs on Chinese consumer goods, not just the current tiffs on industrial and technology product and components.
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The obvious goal was public preparation for Tariffs and the directly resulting rising US Goods Inflation.
Part of the second wave on inflation we have been warning about throughout Q1 that Yellen’s direction of De-Globalization and De-Risking will inevitably lead to.
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It will be a contributor in addition to already in the inflation pipeline such as Service Inflation, Energy, Food and unaffordable shelter
Tariffs and heightened possibilities of escalating Chinese "Trade Wars" are now a real possibility.
The result will be rising Consumer Goods prices in the US since China is a dominant supplier of almost everything in the average American home or apartment.
This will all be part of Wave 2 of US Inflation. - something that the US Consumer must be prepared for, or at least for the government to have demonstrated it did everything possible before bringing the "hammer fully down" on Tariffs - after the election is over.
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EVENTUALLY, A FAILED US INDUSTRIAL POLICY WILL HIDE BEHIND ACCUSATIONS OF CURRENCY MANIPULATION
Continued Inflation in the US, especially as it impacts the consumer, is a major problem in a 70% based economy. There is a strong likelihood that the US dollar will deteriorate as trade deficits increase, compounding the problem.
Expect China to be accused of currency manipulation when the battle heats up.
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The concealed reason for the trip is to attempt to re-establish China as a Buyer of US Treasury Bonds or minimally to stop the unwinding of its Treasury holdings and reduce De-Dollarization efforts by the ever expanding BRICS-10 trading bloc.
That was going to be a tough sell even for a political operative and manipulator of the proven stature of a Janet Yellen!
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China’s selling of its holdings of US Treasury debt is a major problem for Yellen and the US.
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For the 9th month of the last 11, China's Treasury holdings declined in February (the latest TIC data), dropping by $22.7BN. Additionally, it has now been 24 of the last 28 months that China's Treasury holdings have declined; now back at practically its lowest level since June 2009.
As of January 2024, China owned $797.7 billion in U.S. Treasuries, which is roughly 10% of the U.S. national debt. This is the lowest share of outstanding Treasuries in 22 years, and down from the record 14% in 2011 WHEN IT WAS ~1.3T and only marginally smaller than Japan as the largest holder of US debt.
As this chart illustrates, the problem is only getting worse and at a faster rate.
China’s on-going dumping of Treasury holdings couldn't come at a worse time with the US Treasury needing to finance unprecedented spending deficits. The US deficit estimates only mid-year into the current fiscal year are presently estimated to be between $1.5 - $2.1 TRILLION.- approaching 8% of GDP.
Treasury Secretary Janet Yellen needs buyers of this debt and the vast amount of the existing $34T coming due and needing to be rolled over.
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While we are acutely aware of the fact that 'correlation is not causation', one would find it hard to argue that the practically perfect overlay of China's Treasury holdings and the yield of the US 10Y Treasury note over the past three years, it makes us wonder, if - away from The QT, The FedSpeak, the macro-economy, the geopolitical crises, the AI-hype, the growth scares - it's not just all a well-managed (though slow and steady) liquidation of China's still massive US Treasury holdings.
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It's hard to argue that China doesn't have an incentive to:
- a) de-dollarize, or
- b) not liquidate it all at once, shooting themselves in the foot.
While the de-dollarizing has been steady in Treasury-land (enabled by a vast sea of liquid other players), things have been a little more 'obvious' in the alternative currency space like gold.
The 2015 jump in the chart showN here was when China suddenly admitted to its gold holdings (well some of them we assume) after no disclosure since 2009. Since then both China and Russia (shown by the gold line at the bottom have been hoarding the precious metal while dumping Treasuries.
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This illustration consisting of two panes – an upper and lower - may be a little difficult to see.
The Upper pane compares the inverse of US Treasury Yields to Chinese Treasury holdings while the lower overlay the combined gold buying of China and Russia.
What is happening is:
- There is an almost perfect correlation in the top pane of China selling its US Treasury holdings with falling prices of those US Treasuries from selling pressures. As you aware as prices for Treasury fall, the Yields go up.
- China selling is having a clear impact on rising US Treasuries as there is not another major player to both pick up the selling from China but also to absorb the massive increase in the US deficit from historic levels of spending.
- The lower pane shows a strong correlation with where that money is going. It is helping to pay for the major gold accumulation underway in China and Russia – and not included here also by the BRICS-10 alliance - lead by China.
- The vertical red line in January 2021 shows the change of US Presidential leadership and a new administrative regime. It clearly shows that something then contributed in some way to this shift or at least the acceleration.
Again, as the top panes vertical red line indicates, the impact of China’s selling of US Treasuries has accelerated since Janet Yellen and the Biden Administration assumed power. Yellen was quite quick in immediately reacting to the problem.
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Yellen quickly began using the Treasury General Account (TGA) along with other methods to control the damage and additionally allow the funding of massive new fiscal deficits.
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I have previously laid out in my newsletters as matters unfolded how Yellen did this through Two Stages of Stealth Liquidity and Treasury Funding as summarized here.
After the Biden Administration masterfully orchestrated the suspension of the debt ceiling until after the Presidential Election, Yellen was set free to tackle the problem. The Bank Term Funding Program (or BTFP) which had been implemented three months earlier allowed the shift in massive reserves held at the Federal Reserve in Reverse Repos.
STAGE I was centered on using the $2.7T Reverse Repo holdings at the Fed to flow through the US Treasury primarily in the offering of short term T-Bill Treasury funding.
The REPO asset drawdown was taken down to ~$350B today for a liquidity insertion of ~$2.4T.
As Stage I was run down, Yellen & the Fed then triggered Stage II which allowed the major banks to “arb” nearly $52B from BTFP trading to expand its lending facilities in dramatic fashion. In turn this expanded $52T was used to effectively create unlimited money to buy US Treasuries when it was moved through high leverage hedge funds in the form of leverage loans for them to buy longer dated US Treasury notes and bonds.
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This all worked exceeding well until recently!
Suddenly the auctions hit a brick wall and auctions tails were at unprecedented levels. There was a buyers strike by the Leverage Hedge Funds expected to buy the Treasury offerings.
Yellen’s trip required her to ideally get China to buy US debt with its currency reserves, BUT minimally she needed to convince China to stop selling US Treasury holdings – at least temporarily.
If she couldn’t do that, she needed to convince China in her negotiations to assist in slowing the rapidly expanding and powerful BRICS-10 trade consortium in reducing its De-Dollarization strategies in the near term.
She needed to convince everyone it is in their best interest.
Yellen was also acutely aware that when the Fed does finally pivot and starts reducing rates, it will place downward pressure on the dollar making US imported goods even more expensive by basically importing inflation.
She needed an agreement with China, that they would maintain their international currency against the US and react constructively when the US began placing fully expected Tariffs on Chinese imports.
Not at all an easy sell but somewhat palatable if everyone saw that a Fed Rate Pivot could be expected to weaken the Us dollar, which all Emerging Markets and BRIC-10 membership were screaming at the IMF to make happen.
The China meeting also became an urgent meeting because of yet another very important factor.
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Every 4 months or three times a year Yellen must release the expected treasury offerings that will be available during the next cycle of Treasury Auctions. As the 10Y US Treasury Yield chart below illustrates, EVERY TIME this document is issued - see the three orange bubbles on the left - it instigated a sustained trend direction.
Yellen needs the next release due to be released on May 1st to initiate a downward trend DIRECTION.
Yellen needs to take the load off debt interest payments NOW and insure the auctions deliver the buyers needed. She can’t count of the Fed Pivoting quite yet without a serious crisis triggered the Fed. Something no one wants in a critical election year.
The under-appreciated driver for the "CAP-IN-HAND" urgent trip to China is that inflation is only soon to work against lower rates and she needs China's help!
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Over the last 6 weeks we have seen this happen which caught the market off-side.
Rates as shown here have shot higher, and will keep going if something isn’t done. Especially when the Fed is reiterating that “higher for longer” is the required direction.
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What we haven’t talked about yet is where China is on all this?
What do they need to leverage Yellen’s problems to China’s benefit?
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Unlike the US where nearly 70% of the economy is consumption driven, China’s economy is 43% dependent on Capital Formation and Foreign Direct Investment (FDI).
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It is quite literally in freefall as a result of Xi Jinping’s recent shift towards less friendly treatment of foreign corporations anti -US business policies.
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Not only has foreign investment stopped but profits are being repatriated versus reinvested in China.
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Separately, China’s manufacturing unit labor costs per hour have become a major problem against the other Asian alternatives.
As a result Xi Jinping and the CCP are facing 22-24% youth unemployment because new job growth is not growing fast enough.
The youth is more educated than only two decades ago as Chinese farmers moved from the rice patties to the cities for work and a higher standard of living. Their children are educated and want jobs which build on their education. They don’t want factory work!
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The US as a nearly 70% consumption economy and the Euro Zone as ~ 55% consumption economy are critical demand drivers of the Chinese manufacturing juggernaut.
However, when the Chinese Manufacturing juggernaut reaches a point where it actually begins slowing the rate of economic growth of those countries buying its products, something happens.
Job growth and wage growth slows in the consuming countries and with it Consumer demand growth slows as jobs are lost and competition disappears. This is the slow starvation of what I have been referring to as the Golden Goose.
Has China potentially now reached such a point? Is this at the core root of China's current dilemma? Let's examine the possibility more closely.
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The U.S. and partners—especially the European Union and also Japan—are concerned about China's manufacturing "overcapacity." President Joe Biden, as Yellen reiterated in China “ would not allow another "China shock."
After China's accession to the World Trade Organization in late 2001, the country flooded the U.S. and others with goods. The "shock" then resulted in the loss of 2 million American factory jobs.
"China is now simply too large for the rest of the world to absorb this enormous capacity," Yellen recently said . "Actions taken by the PRC today can shift world prices. And when the global market is flooded by artificially cheap Chinese products, the viability of American and other foreign firms is put into question."
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First it is important to understand the reality that China is "Supply" driven and the US is “Demand” driven.
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There was no shortage for China’s cheaper products and as such it is about increasing & broadening production and thereby supply. This reflects itself in the fact as I already mentioned that Chinese economic growth is ~ 43% Gross Capital Formation built on Foreign Direct Investment (FDI).
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The US on the other hand has become a country built on "Demand" or consumption. At nearly 70%, this is the primary driver of the US economy. The US is a country where high wages and easy, affordable financing allows this consumption.
Supply = Production v Demand = Consumption
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The ever expanding US Trade Deficit means the US consumes more than it produces.
This difference must be financed. Until recently this hasn't been a problem, but with a staggering debt to GDP of 130% the financing of the debt is shrinking the available domestic capital stock, making it more dependent on foreign investment.
Production = Investment Capital -- Consumption = Financing, Jobs & Workers (Immigration)
The US needs foreign investment to allow the financing of consumption (Demand), while China needs foreign investment to finance Production (Supply).
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Unbalanced due to Chinese Over-Production ("Over Capacity")
China's overcapacity is not the product of a mistake. It is the inevitable result of the Communist Party's economic system. There is a shortage of domestic demand due to Beijing's policies designed to depress consumption. Therefore, the country exports its excess industrial supply. Chinese goods depress prices in foreign markets, which results in foreign businesses failing.
"China creates overcapacity because giving money to bureaucrats and state-owned companies is what the system knows how to do," Anne Stevenson-Yang of J Capital Research USA said this week. "Building new factories make it look like China is growing, even when demand is falling."
Both China and the US have enabled each other since China entered the World Trade Organization (WTO) in 2001. China adopted the proven export mercantile strategy that Japan did. China took its rapidly expanding currency reserves and bought US Treasury Bonds to hold those reserves in. This made consumer financing rates in the US smaller (taking yields down), while also strengthening the dollar (making Chinese goods cheaper for Americans to buy). The strategy worked as it initially did for Japan.
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As this chart shows however, China's Supply has taken on such a commanding position in the world (the Manufacturer to the World) that it is now steadily stripping jobs from its export countries. The buyers of Chinese products are seeing their consumption being weakened as jobs and economic growth comes under pressure.
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The Chinese Strategy
The Chinese Strategy to increase Production is to go "up-scale" or to increase the production of higher value-add products. Until recently this has been the protected domain of the developed countries that allowed high paying jobs and consumption. Xi Jinping is very clear that is where they are going and will not be deterred.
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Xi Jinping is reluctant to reverse policies that depress consumption because that would offend key constituencies in the Communist Party as well as undermine the solvency of the banks, which underpin the Chinese economic system. Moreover, Xi does not want to empower consumers. Finally, he is intent on putting China on a wartime footing, which means he's determined to build even more industrial capacity.
In Xi Jinping’s last trip to the US he met with US business executives in San Francisco to re-assure them about investing in China. Whatever he said was met with 3 standing ovations of approval.
Xi just finished yet another meeting in Beijing with global business leaders.
He will not be deterred. As would be expected the business leaders will ride whatever horse will deliver profits and growth with assurances they can operate effectively knowing their investments will be secure.
Time will tell whether Xi can be trusted or whether he is a better bet than whoever runs the next administration.
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The US Strategy
The US Strategy has increasingly therefore becomes one of heading towards:
- Tariffs
- Protective Regulations and
- De-Risking and On-Shoring
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De-risking and On-Shoring has a lot of merit but unfortunately the US has gutted its manufacturing prowess over the last two decades. It will take a decade to re-train the skills that were once so prevalent in the industrial giant the US was as late as the 1990’s
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Frankly, the strategy of both is highly likely to only result in the mutual killing of the Golden Goose of global economic prosperity.
It is almost assured we are on a collision course which is doomed to only result in heightened Global Conflict.
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The current strategic thinking will no doubt go through more than a few morphing adjustments. The real issue is what is Yellen going to do within the financial funding realities she faces?
We have watched Yellen closely for a few years now and the one thing we are certain of is that she is a master manipulator and can be counted on to come up with a devious way to achieve what she needs.
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It is our studied opinion Yellen has a trump card she is about to play.
Remember, we got out of the 2008 financial crisis by altering behind the scenes the accounting of bank Derivative holdings. We removed the requirement for “Mark-to-Market” for derivatives and went to what has become laughably referred to as “Mark to Magic”.
These changes by the way have never been reversed.
One thing you can count on with governments is that when the going gets tough they cheat or change the rules. They are one of the few entities that can get away with such a proven and given approach.
Yellen must maintain the continued funding growth for US Treasury debt!
The latest game of trickery we believe is going to be to the alimentation of Treasury holdings from the SLR (Supplemental Liquidity Ratio) calculation, which is used to determine how much banks need to set-aside to help “manage risk”.
Though we supposedly have a strong economy, the Treasury is selling/issuing bonds at a rate last seen during the Covid crisis.
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The new SLR rule change could allow banks to be an endless buyer of treasury debt.
How convenient for the banks -- to be able to buy treasuries, take no haircut, and not have to worry about mark-to-market losses. All just in time, as issuances are taking on a life of their own! The Great Taking which we outlined in our Annual Thesis Paper: "The Regulatory Sate", revealed that the bond market is also fractionalized (not enough to go around/some bonds held on the books by more than one owner).
It is increasingly sounding like a risky proposition to keep calling our government bonds “pristine collateral” or “risk-free”, or a “safe-haven assets”. Maybe we should call them what they are - not Bonds - but rather "Bombs"!
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So what can we conclude?
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Everything we have discussed leads to one conclusion. We are heading towards an era of Currency Wars
We saw this when Britain relinquished global leadership to the US in the 30’s.
When global finance becomes a problem the first weapon of choice of governments is their currency.
Whether to gain competitive export price advantage; control competitive total bond yields; or to export inflation CURRNCIES are always the name of the game.
The US Dollar is extremely over-valued and is ripe for attack! The BRICS-10 and global commodity/oil producers are well aware of this.
The US no longer has the PetroDollar, Yen Carry Trade, Riskless Treasury Bonds nor unquestioned Reserve Currency status to hide behind which we had in the 1970’s era of inflation.
Additionally, the US has a chronic problem of producing less than it consumes which makes it unfit for the currency battles ahead without some profound changes.
Cheating never solves real problems for long!!
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As I always remind you in these videos, remember politicians and Central Banks will print the money to solve any and all problems, until such time as no one will take the money or it is of no value.
That day is still in the future so take advantage of the opportunities as they currently exist.
Investing is always easier when you know with relative certainty how the powers to be will react. Your chances of success go up dramatically.
The powers to be are now effectively trapped by policies of fiat currencies, unsound money, political polarization and global policy paralysis.
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I would like take a moment as a reminder
DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are for educational and discussions purposes ONLY.
As negative as these comments often are, there has seldom been a better time for investing. However, it requires careful analysis and not following what have traditionally been the true and tried approaches.
Do your reading and make sure you have a knowledgeable and well informed financial advisor.
So until we talk again, may 2024 turn out to be an outstanding investment year for you and your family?
I sincerely thank you for listening!
