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Japan and China - The Wild Card in the Bond Market

Last Thanksgiving evening, the bond and dollar markets were sent reeling by a report in a Chinese business newspaper quoting an advisor to the Chinese monetary authorities that China was scaling back its purchases of dollar-denominated assets.

While he later backtracked on his comments, it was too late to repair the damage this man's statements caused to both the dollar and the bond market. The proverbial cat had been let out of the bag so to speak.

Bond pitsters responded immediately by jettsoning long positions as did dollar holders. The resulting overnight move sent interest rates moving up sharply on the long end and kicked gold easily through the heretofore tough resistance area near $450. Monday November 29 saw a continuation of the selloff in bonds and a further move up in the gold price.

I would like to make just a few brief comments concerning this development as I believe it has enormous implications for gold due to its effect on both the dollar and long term interest rates.

Please note the following charts I have constructed from the data supplied by the U.S. Treasury as it pertains to U.S. Treasury holdings of the nations of Japan and China. It is my opinion that these two nations have mainly been responsible for the low interest rate environment here in the U.S. as they recycle their trade surpluses back into dollar-denominated debt. Simply put, they are the buyers of size in the bond market and without their massive purchases of U.S. debt, long term rates would have risen already and would not be at these ridiculously low levels in the face of a collapsing dollar and a soaring CRB index.

The first chart details the total holdings of U.S. Treasuries by both Japan and China. One can see that both nations have been steadily increasing their holdings with those of Japan dwarfing those of China. Japan is the area in blue; China is the area in red. This is all well and good but I believe the data in this format does not paint an accurate picture of what is really taking place. For that, a few modifications and additional calculations with the data are much more conducive.

One thing that I have done rather than simply charting the dollar amounts of Treasury holdings is to chart the PERCENTAGE CHANGE of INCREASE or DECREASE when compared to the same month one year earlier. I believe the data in this format is far more revealing.

While the raw data reveals that both China and Japan have been steadily increasing their purchases of U.S. Treasuries, the data in this format shown in the second chart demonstrates that China in particular has been SLOWING DOWN THE RATE OF THEIR PURCHASES. One can easily detect the downtrend as illustrated by the RED line in the second chart. The same holds true for Japan, although to a lesser extent as the downtrend in their rate of purchases has only turned down since April of this year.

I believe this is a critical development as it pertains to the long term welfare of the dollar. China and Japan need not necessarily divest themselves of their U.S. Treasury holdings to send the dollar swooning further. All that they need do is to continue to slow down their RATE of Treasury paper purchases.

Since these two nations have been a significant source of demand for U.S. Treasuries, such a reduction will remove a floor of support under the long end of the yield curve, resulting in higher long term interest rates. At the same time, it will serve to further weaken dollar demand which will add even more pressure on the beleagured greenback.

All this of course will serve to bolster gold's prospects. As a matter of fact, I believe this is the last ingredient which is needed to kick gold into a rapid acceleration phase and send it vaulting above the $500 level.

The worse case scenario will see both of these nations, not to mention others as well, actually unloading Treasury paper on the global market. If such a case were to occur, the market would have no choice but to respond by driving interest rates sharply higher in an attempt to stimulate capital inflows and prevent a mass exodus out of U.S. paper. This is the nightmare that no sane thinking individual welcomes since its final repercussions will effect the U.S. Economy in ways that are too horrific to consider.

I leave you with a final chart of the long bond which speaks for itself. I do not believe it is a coincidence that bonds are breaking down and are periously close to confirming a major top as the news surfaces about China and Japan beginning to express concern over the sheer size of the U.S. Treasury holdings in their official reserves. We are on the verge of seeing these days of 40+ year low interest rates gone for a very, very long time.

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