The US-China-Australia love triangle
First of all, just a notification: our Trades tab page has been updated with new trades, closed/stopped-out positions, and updated PnL's.
Now to the post...
The pre-crisis status quo in regards to US-China economic relations involved the United States exporting USDs to China via consumption for Chinese exports. China recycled these USDs into Tsys, which fueled further consumption and increasing imbalances. With the crisis at hand, however, China is now forced to choose between continuining its bid for quickly-debasing UST's or rethinking its investment strategy.
With its announcement of a record trade deficit for March, China seems to be posturing for reallocating its surpluses away from US exposure. Falling exports surely impacted China's trade balance but the bigger issue is China's new appetite for commodities, importing hoards of them from places like Australia. This is confirmed by the fact that China's Bills exposure has declined more than 67% in just one year! It is evident China is not rolling its Bills held and instead is bidding for commodities (its imports are up over 60% YoY).
The reallocation away from US short-term debt into hard assets is clearly an inflation hedge play. Commodities (particularly copper) have surged, as have risk assets as a whole, while Tsy rates have been spiking and are in fact approaching breakout.
The US Treasury needs a bid for Bills to keep interest expense at reasonable levels or it will go the way of Greece. Record deficit spending and debt issuance, coupled with spiking CDS and a lack of Bills rolling from China, means the Tsy is incentivized for a risk asset selloff to spur demand into liquid safe havens, in which the USD/Bills still hold the crown, on a relative basis.
Without a surge in organic Bills demand, the USA will have a funding crisis and very bad inflation. This is not only bearish for the US, but for the entire world, because of the USD's role as the international reserve currency, the US's political and militaristic positions, and the massive foreign holdings of USD and UST's. More Fed demand via QE also would spike rates, as 10yr yields went up 25% in just the first (and thus far only) iteration of QE, in less than a year.
As per trading, the key will be the AUD. It seems to be topping and a 200DMA break signals a great short opportunity and more importantly signals an end to the China-fueled commodities imports demand (at least temporarily). Given the game theory behind the US Tsy's relations with the rest of the world, we also believe this would signal a risk asset sell-off for capital reallocation into Tsys, at the front end of the curve. The deleveraging and fundamentals on the real economy support this, but timing is key. An AUD/USD breakdown should signal a breakdown in risk assets across the board, and commodities indeed are already topping and beginning new downtrends (energy is the weakest sector in equity at the moment). We will be shorting in size the S&P and the AUD/USD on a 200DMA breakdown. A breakout through 0.935 invalidates this thesis and would lead to us stalking a long position (if there is sufficient follow-through to define it as a breakout), but would also presumably lead to plunging Tsys (yields are already on the verge of breakout, especially in the 10 and 30yr arena). Considering the inverted swap spreads anywhre from 7yr to 30yr bases and the unique position America is in politically and economically, we believe short-term deflation risk and an "engineered" reallocation from risk assets into Bills is the more likely scenario.
Below are charts showing the AUD's overvaluation, courtesy of Citi.