July 2005

China & The Chairman

Bowing to pressure from the U.S., Germany and Japan, China un-pegged its’ currency from the U.S. dollar in favor of using an unspecified basket of currencies. Many have argued that an artificially low yuan has unfairly helped China with trade - boosting Chinese exports and making imports into China less competitive. The People’s Bank of China will allow the yuan to float within a band of 0.3%, and, in a symbolic gesture, let its currency rise against the dollar by a modest 2 percent overnight. Many consider this long-awaited move by China only the beginning in a series of currency revaluations. A time-table for further currency readjustment is uncertain.

A fear for the fixed-income markets is that China may reduce its future purchases of U.S. government debt, which has for some time helped support our deficit spending. Mr. Greenspan's efforts at raising rates are supported by the need to finance our current account deficit and attract foreign purchasers of dollar-denominated debt. China is the second largest holder of U.S. Treasuries with more than $243 billion, up from $165 billion just one year earlier. Japan is the largest holder of U.S. debt with $686 billion, according to the U.S. Treasury Department.

On another end of the money trail, Fed Chairman Alan Greenspan addressed Congress on July 20th in his semiannual Monetary Policy Report. Mr. Greenspan stated “Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny.” Namely, these uncertainties include: the housing market, unit labor costs, energy prices, and long-term interest rates. In short, Mr. Greenspan uncharacteristically appeared to put his cards face up on the table, if you will, and he is leading with the higher interest rates card. We suspect that the Chairman will want to exit his tenure at the Fed this coming January with relative neutrality and in so doing will continue to increase short-term interest rates to near historic norms thereby countering prior monetary accommodations.