Friday, February 16, 2007

Bonds and Interest Rate Risk

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As China becomes more daring with its $1.07 Trillion stash, what should we expect to happen? And, why is China becoming more daring to begin with? A recent article in The Wall Street Journal notes that
If current trends continue, the reserves could top $2 trillion by the end of the decade. That rapid growth has given China the confidence to rethink how it manages its holdings, because now there is generally agreed to be more than enough to back up the yuan in case of financial disaster.
First, interest rates seem to be heading up or at least seem to be staying at higher levels than previous years. China, therefore, is exposed to some significant interest rate risk, particularly as there's no end in sight in U.S. defense spending and economic cost of U.S. occupation of Iraq.

Given this environment, it makes sense for China to reduce its interest rate risk by diversifying its maturities and expected interest rates on its assets, currently held in U.S. treasuries, much of which came with coupon rates lower than those today.

As China unloads the bonds, their value will be reduced, further pushing yields higher, first in the shorter maturity bond markets and perhaps later, depending on the extent of China's diversification, in the longer maturity bond markets.

Scholars suggest China could spare perhaps $200 billion or $300 billion from its reserves for more aggressive investments.

Even a slight shift of this type could have a significant impact in U.S. markets. China has long been one of the biggest buyers of Treasury notes, making it in effect a major lender to the U.S. government. China's buying has helped keep interest rates low in the U.S.: The greater the demand for a country's bonds, the lower the interest rates the country needs to offer.

This story promises an interesting unfolding!

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