Tuesday, October 14, 2008


The US is the worlds largest consumer, especially China's. China in turn holds a quarter of dollar forex reserves. China lends this money back to the US and the US banks to its consumers who in turn buy 'made in china'. Now with the liquidity crisis, and some sort of economic realisation, if consumers borrow less and spend less, Chinese exports will take a hit. If exports drop sufficiently to weaken the trade dependency, China would sell some of its forex reserves for which it could call on some of its debt to the US.

With the current trade deficit, America needs debt to sustain its economy, and additional debt to service the initial debt. Till before this crisis the world saw the US as a credit worthy entity. If the worlds creditor nations see the US's credit worthiness drop, expect debt getting more costly.
If nations reduce their dollar holdings the dollar will devalue, which in the current climate will only accentuate inflationary pressures on it thus increasing the expected yields on holding the dollar, of course through treasury bonds etc.

Thus this flight to liquidity, where people are buying treasury bonds moving away from corporate bonds might be flipped right on its head. Treasury bonds will get cheaper, so there will come a time when one would want to go short on treasury bonds. The only issue is finding something to go long on.