Written by: Anonymous

Are you looking for an alternative way to scare the shit out of yourself? Is the prospect of a rogue containership or a renegade produce truck just not doing it anymore? Has the exercise of appreciating the nuances of the Homeland Security spectrum left you as you would lay counting sheep?

Looking for a new nail-biter?

How's about China and her gold?

In a post that should make Answerman smile - we are gonna look at the possibilities for a Chinese-led financial maelstrom.

Producers and London Metals Market participants have known for a while now that China's seemingly insatiable demand for commodity goods extends to gold. Some muse that the Central Bank of China is amassing positions in the metal to counter inflationary forces, should their red-hot economy make like a Saturn rocket.

But others suggest that this is a flawed view. China's economy, even though it flirts with double-digit aggregate demand growth (which is insanely high), enjoys an artificial inflation-check: their decision in the late 90's to peg their currency, the Yuan, to the US Dollar, to the tune of ~ 8.5 Y/USD.

In order to do this, China necessarily relinquishes control of their domestic interest rates, which must mimic those of the country they have pegged their currency to (in the world of monetary policy, you can either decide to control interest rates or currency rates, but not both). So, China has an interest rate environment that is quite similar to ours. They have a stronger economy than ours, so these rates are artificially low, allowing Chinese businesses to produce more goods at lower costs than they should be able to.

They sell these competitively-priced goods to world consumers, the largest of which is the United States. The US consumers buy these goods with USD and the Chinese merchants flip their dollars to Yuan with the Chinese government. Now, the Chinese government can do one of two things with their new dollars. They can chose to 1) sell them in the open market, causing the USD to depreciate, which in turn causes US I rates, and per above, Chinese rates, to rise, or they can 2) buy US Treasuries with their new dollars, which delivers incremental demand for US Debt, causing prices to rise and yields, or interest rates, to fall.

Number 2 is a far better choice.

And that is what China has been doing for the better half of a decade. As such, the Central Bank of China (The People's Bank of China) now reports Foreign Exchange Reserves (to be read: our US Treasury book) of around $330 BB. This is up 30% over 12 months. And these are PBOC numbers, an organization not known for its transparency.

So, what's the problem you ask? Well, one reason the 10 yr Treasury has been able to remain below a 4.60% yield, a key level thought to be the line of demarcation for inducing incremental refinancings, is the incredible demand for the paper by the Chinese government, which is a direct result of their businesses selling goods to US consumers.

The process of selling goods to US consumers and keeping the dollars in US Treasuries is analogous to lending money to the US so that they can buy your goods. That's the trade deficit, in a nut shell.

So, as the Chinese build their US Treasury portfolio, they also continue to amass gold. What's the deal?

Some muse that the Chinese can very soon be in a position to revalue the Yuan, that is, unpeg it. Well, that's good news, right? Chinese goods become properly valued on the world stage, and China beings to pay the true cost of financing that is commensurate with their level of economic growth.

But some suggest that China will pull a Shanghai Steamer and back the Yuan with all that gold, creating the world's first "anti-fiat" money in decades. This would result in immediate credibility for the Chinese currency an immediate and decidedly large price appreciation in gold. It would further serve to discredit the assumptions surrounding fiat currency - a real bad day for the USD.

But where does the real terror surface for the US? China then dumps their unknown hundreds billions of dollars worth of US paper onto the market, causing yields to surge, and effectively choking our credit markets. We run out of the ability to monetize government debt, or, make money.

Oops.

The horror comes not from assessing the likelihood of such an event, it is born from the realization that such a play is feasible. It could happen, and would be one of the greatest, if not the greatest of trades in the history of global commerce.