TL;DR: China needs dollars badly, not gay little treasuries yielding 1%. They will not purchase treasuries at the next auctions and interest rates will spike. Chaos in the bonds market will lead to chaos in the stock market. Bears,go in for the kill. Bulls, close your long positions on the 11th and reopen them at noon on the 13th. What makes this play so beautiful is just how well it can be timed. $TLT ATM put 5/15 purchased 5/11.
This post will start off with some ECON 101 for who never learned the basics. If you already know why bond prices move in the opposite direction as interest rates and why China buys so much US debt, then skip ahead. The bond market dwarfs the size of the stock market, there is about 9 times as much outstanding bond value as there is total market cap. Bonds are where the big boys play.
Interest rates and bond pricing
When interest rates rise, the prices of old bonds fall, and when interest rates fall, the prices of old bonds rise.
Consider a zero coupon bond, one where you pay a certain amount and at the end of the bond term you get paid back more (unless you’re a cucked German bond buyer). For a one year bond with a 5% yield, you would pay $95.24 for the privilege of redeeming the bond for $100 in one year[Formula:(end value – price)/price = interest rate]. But what if the next day interest rates fall to 3%? The bond you just bought suddenly looks a lot more attractive. Its yielding a lot more than the bonds the suckas are buying today. If you turned around and sold it the next day, you could scalp off the extra yield and sell it as though it were 3% bond. Using the same formula, you could sell it for $97.04. Nice. If on the other hand, the interest rate rose to 7%then everyone trying to make a buck would want the bonds they buy to yield 7%. In order to sell your 5% bond, you would have to take a loss to make it attractive. The new price of the same bond would be $93.48.
The sensitivity of a bond’s price to interest rates, depends on the bond’s time to maturation.
The more years a bond has to collect interest, the more the rates affect the bond’s price. Consider a 30 year bond that pays 5% a year, compounded annually. In practice, only savings bonds compound, but any bond can be recalculated as if they compound. That bond would cost $231.38 and pay out $1000 at maturation [Formula: end value = price * interest rate ^ years]. If the next day, interest rates increased to 7%, U R FUK. That bond would now sell for a paltry $131.37. If interest rates fell to 3%, your investment would nearly double to $411.99. If they fell to 1% you could sell that bond for $741.93. Damn WSBGod. That’s the power of compound interest. Below in the DD section, there’s a more realistic graph showing approximately how $TLT will respond to interest rate movements.
Interest rates depend upon supply and demand for a bond.
The fundamental rule of microeconomics: prices are set by supply and demand. Therefore, the discount and interest payments of a bond depend crucially on what market participants want, their demand. Suppose you know a company, Widgettech, that sells widgets is run by a complete moron and that Widgettech is trying to raise capital by selling bonds. There’s another company WidgetDotCom, run competently, that currently sells their zero coupon bonds with a 3% discount. Would you buy Widgettech bonds at 3%? Hell no. You need to receive a premium for that. The same is true for government bonds: th eUS 10 year is trading at 0.6% interest while the Brazilian 10 year is trading at 8% interest. Investors need to be compensated for the risk that Brazil can’t pay them back. Demand for crappy bonds is low. Demand for good bonds is high
Supply is another fundamental issue. If you want $100 to YOLO, you could probably get a loan from your dad. If you want to YOLO $10 million you’re going to need to look elsewhere. The larger the loan you want, the more market participants you’re going to need to engage. To get that $10 million you’re probably going to need to put your tin cup before a bunch of banks and all your friends and family. To make them pay any attention to you, you’re going to need to make them a damn good offer. It can’t be the “I’ll pay you back next week” that you might do with your dad. It would have to be “I’ll pay you back an additional 50%.” When a company or nation wants to take on substantially more debt, they will need to raise the interest rate to get more people to drop some change in the tin cup they’re rattling.
US Treasury Bonds and China
Exports naturally lead to a strengthening of the exporter’s currency, but China cockblocks the yuan.
Xijinpingistan’s economy runs on exports; Murica’s economy runs on imports. We get crappy plastic products and China gets dollars. The supply of dollars is high and the supply of yuan is low. The basic laws of supply and demand then dictate that the price of dollars should decrease and the price of yuan should increase. But that doesn’t happen because the People’s Bank of China (PBOC, China’s Fed) steps in.
China wants the yuan to be cheap relative to the currencies fo the countries they export to. You ever wonder why Chinese crap is so cheap? It’s because the yuan is cheap. China manufactures goods at market-determined prices in the local currency. They pay the workers and buy raw materials in yuan. When they export their products, we see a large discount when we buy their products in dollars. This discount is good for both sides: China becomes the world manufacturing hub because everyone wants cheap products, we enjoy the lower costs for Chinese goods and services (and forfeit our jobs).
China keeps the yuan cheap by buying treasury bonds.
When companies sell goods to the US, they receive dollars. However, they need yuan to pay their workers and suppliers. To get yuan they trade with the PBOC. The head of the PBOC, Xi-Roam Pao, fires up the money printers and hands off the freshly printed yuan. Now he’s got dollars to deal with. To make sure the US keeps handing his people dollars, he gives them back to the US i excahnge for US treasury bonds. Treasury bonds are also a nice stable investment for the Chinese sovereign wealth fund. They’re considered the safest investment in the world and once upon a time were one of the highest yielding * investments. Unlike the dumbasses YOLOing our futures with trillion dollar bailouts for the rich, China at least has some fiscal common sense despite their other bullshit.
China currently owns over 1 trillion dollars worth of the US national debt. There’s about 18 trillion worth of debt available to the public and another 6 trillion owned by the US government in the Fed and other funds like social security. So China owns about 6% of the available debt. They also hold another $2 trillion in non-dollar foreign debt of their other trade partners.
**I’m posting with images because it is faster than retyping**
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.