Geopolitical Developments: The Selloff In US Treasuries Will Frustrate China’s Cultural And Geopolitical Ambitions While Its Neighbors Are Crying For Help

US interest rates broke out of their trading ranges and are setting the stage not just for more consolidation in equity markets but also a test for the Chinese Communist Party to maintain its focus and discipline in the face of a weakening global economy and angry neighbors. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), but my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought one positive factor for US stocks. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. The US yield curve is rising and in the current context that is bearish. Expect the S&P 500 to be range-bound over the next few days.

As I noted earlier this week, the markets are levered to a stable and rational China, and to date both the Communist Party’s (CCP) aggressive foreign policies against India and its China Sea neighbors as well as its leftward tilt toward cultural leftism are evidence of a confident government attempting to lay the cultural foundations for long-term rule. The problems the CCP face are less that the Chinese citizenry tires of its brutish paternalism but that the US and other culturally hostile nations put the CCP down and catalyze a drop in confidence, leading to mass demands for liberal democracy. The key lever the US has at the moment to cut the CCP down to size is Federal Reserve policy, since higher interest rates weaken the global economy and hit China where it’s vulnerable, since its own economy is weakening and fragile.

S&P notes “Beijing's latest attempts to free up more liquidity for lending are too modest to revive credit growth, which has slowed to its lowest pace in more than 15 years, analysts said. The easing measures, which include lowering banks' required reserve ratio and a 5-basis-point cut to a benchmark interest rate late last year, will also likely keep banks' net interest margins at multiyear lows…Meanwhile, softening economic growth, the ongoing debt problems among property developers and the end of loan repayment extensions for small businesses are set to heighten the credit risk for lenders, especially the less capitalized ones with more concentrated loan portfolios, analysts added…We expect China to use more policy-easing measures — such as proactive fiscal policy, prudent monetary policy as well as targeted industrial policies — to prevent a downward spiral and reverse a sharp growth slowdown," China Renaissance Securities said in a Jan. 3 report.“

So the CCP will be forced to act and increase spending despite its cultural and geopolitical priorities. Its leftist policy of curbing credit to property speculators and strengthening the lending standards of its banks is in jeopardy, as S&P further notes: “While many banks hold back from lending to highly leveraged developers and set aside more provisions against loan losses, the authorities have been nudging lenders to extend more loans to small and vulnerable businesses at affordable rates, adding risk to their asset quality and earnings…The credit risk from small businesses will likely rise after the government-mandated extension of loan repayment for those borrowers ended at the end of 2021, analysts added…Lending [to small businesses] presents challenges on risk control, it may not be easy to drive substantial growth on loans," Simmons' Cai said.“

Key to watch is whether this frustration of CCP goals spills over into geopolitical or diplomatic mistakes. Continued protests in Pakistan against Chinese involvement has already soured diplomatic relations. The unrest in neighboring Kazakhstan and the heavy Russian involvement will be the next crucial test.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), American Express (AXP), Johnson & Johnson (JNJ), 3M (MMM), Titan Machinery (TITN) and a small net long position in the S&P 500 (the levered inverse ETF SPXU and levered ETF UPRO).