European Banks, China Investors and US Consumers

This post is written with the yield on the 30-year treasury floating back up above 3%. This yield is significant because it is a sharp bounce off of the recent low, it suggests the markets anticipate an improving economy largely due to a bail-out in Europe, and it calls into question the level to which the Federal Reserve would like push down long-term yields. In this post I focus on economic stresses caused by volatile markets, arriving at the conclusion that I should hold, for now, the treasury position based on my belief that today's rally is a "dead cat" bounce that ultimately turns back down. That said, it is becoming more difficult to separate volatility from longer-term moves and I have noted that treasury yields can bottom before equity markets.

In my last post on 30-year treasuries, I mentioned that I believe it may take until June 2012 for the full impact of the recent market volatility to completely impact equities. There are a few signs emerging of real world stress on economic activity.

According the WSJ, the rise of perceived risk in European banks has made it more difficult for them to issue new debt. The banks have only issued $34 billion of senior unsecured debt this quarter, on track to being the lowest issuance in any quarter in over a decade. The timing, as is usually the case during a crisis, stinks because of an estimated $1 trillion of debt coming due next year. There is still time for the banks to issue enough debt to meet the required financing of maturing debts. But, the issue is becoming more pressing and the banks potentially have to accept higher rates, placing further pressure on their business.

Adding to the potential hit is the increasing likelihood of new capital requirements for banks, as international regulators push to require banks to hold extra capital. This change would require US banks, collectively, to raise an extra $200 billion in common equity. At a time when most US banks stocks are depressed, this requirement could prove costly.

In Asia it is worth noting that China is actually actively attempting to raise the value of its currency. The effort is a result of rising inflation in the country. A stronger yuan helps hold down inflation since imports become less expensive, albeit at the expense of exports and potentially the economy. The key takeaway, in my view, is that investor money has been leaving China as growth opportunities lessen and perceived risk increases. I am not the only one noticing a familiar trend that portends a significant bear market in equities.

Finally, add in the depressed state of US consumer confidence, which was below expectations, and the potential for problems for equity markets over the next few quarters are magnified.