For the moment relief from China is trumping negative news from the United States.
In New York today, the Standard & Poor’s 500 index closed up 0.61%. In Europe Germany’s DAX Index closed up 0.62% and Spain’s IBEX 35 index finished up 1.24%. Overnight Shanghai edged upwards 0.26% and, in what amounts to a positive day given recent punishment, Hong Kong’s Hang Seng fell by just 0.07% and Tokyo’s Nikkei 225 by just 0.17%.
Relief from China stems from a decision by the Industrial & Commercial Bank of China, China’s biggest lender, to stand behind a trust product issued by China Credit Trust. Industrial and Commercial Bank, which distributed the trust, has told investors in the trust that unidentified buyers have agreed to buy rights in the trust at a price equal to the value of the principal invested. The trust, Credit Equals Gold No. 1, is due to mature on January 31, and because the trust had invested in a failed coal mining company, which is unable to repay investors in the trust, those investors were looking at the loss of their principal.
Which is a big deal since Chinese investors, despite any fine print to the contrary, believe that principle invested in trusts like this is safe. And since assets managed by China’s 67 trusts hit $1.67 trillion in September, according to the China Trust Association. That’s a 60% increase in the last year. The failure of Credit Equals Gold No. 1, financial markets feared, would lead to a wave of defaults in trusts and related products in China’s shadow banking sector. Debt issued by companies affiliated by local governments, was an especial concern. Local governments can’t issue debt directly so these products rely on an implicit guarantee of safety. With local government revenue dependent on land prices and payments from developers, financial markets have become increasingly leery of that implicit guarantee. Not exactly a minor issue for the markets since debt owed by companies set up by local governments hit 17.9 trillion yuan ($2.96 trillion) at the end of June, up from 10.7 trillion ($1.77 trillion) at the end of 2010, according to the National Audit Office. These local-government affiliates faced repaying 299.5 billion yuan ($49.5 billion) in bonds in 2014, according to Everbright Securities.
This problem had driven average yields on five-year AA rated notes (this is the most common rating for local government affiliated debt) to 7.6%. The price of insuring Chinese government bonds against default in the CDS (credit default swap) market jumped 14 basis points to hit 105 basis points last week. That’s a 15.4% increase in a week, if you’re playing along at home.
The worry, of course, is that this 15% increase in the cost of insurance would ripple out in the market in the form of higher rates for borrowers and, worst case, a tightening of credit so that some borrowers couldn’t get financing at all.
And it’s that worry that has receded a bit today. Credit default swaps have fallen back to 96 basis points and the yield on five-year AA notes retreated slightly to 7.58%.
For the moment, fears that China was facing an immediate default crisis in the trust and local government debt sectors have receded.
And since those fears were a major driver in the emerging markets sell off of the last two weeks, good news on this front has been more than enough today to offset a surprise slump in U.S. orders for durable goods. Orders for durable goods (goods expected to last for at least three years) fell 4.3% in December. Orders excluding transportation (a less volatile series since it excludes aircraft orders that can produce big swings just on timing) fell 1.6%. Economists surveyed by Briefing.com had expected orders excluding transportation to climb 0.6% in the month. The weakness in orders hit just about every sector and stands in a huge contrast to the purchasing managers index, which had shown increasing U.S. economic strength in manufacturing in December.
Is this weakness enough to change the Federal Reserve Open Market Committee’s decision tomorrow on whether to cut monthly purchases of Treasuries and mortgage-backed securities by another $10 billion to $65 billion? (In December the Fed announced that it would taper off these purchases to $75 billion from $85 billion.) I suspect not and I think that the Fed will vote for predictability versus reaction to short-term data. The weakness in durables, however, does just about guarantee that the Fed won’t get or sound aggressive about future tapers. I doubt that will be enough to assure traders worried about emerging market currencies. But at least it shouldn’t make a bad trend worse.
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