Please, China, Sell Your Treasury Notes!

One more post on Krugman, if I may, and then I'll move on. Check out the chart he reproduced on Saturday: it looks very much like it comes from the Economist, but I can't find the specific article. In any case, it shows the violent volatility in the credit markets, using the spread between Libor and Treasury yields as a proxy.

Tyler Cowen has a lot of questions:

Why markets are self-destructing in this way remains a puzzle; dump on markets all you want but why here and now?...
Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity? Are such revaluations always so bumpy and so lacking in locally stable iterative processes?

I think in general it's clear that deleveraging is always going to be more chaotic and bumpy than the overleveraging one sees on the way up. And it's also clear that the spikes in the chart corrrespond to a series of asset classes being re-rated from "safe and liquid" to, well, not safe and not liquid. First there was the interbank market, then ABCP, then anything wrapped by the monolines, then auction-rate securities, and now the agencies.

The good news is that I think we might now have reached the limit of fixed-income asset classes which can suffer an exodus of investors who thought they were taking no credit risk and no liquidity risk. The bad news, of course, is that the asset classes which have already been hit could get much worse before they get any better. And the arbitrageurs - the hedge funds and others who in an efficient market would be jumping in at this point and snatching up high-yielding ultra-safe instruments - all mark to market and therefore risk getting big margin calls if things continue to get worse. Besides, their own cost of funds these days is pretty high.

It's probably too much to hope that the US government itself might start embarking on a massive carry trade, issuing two-year notes at 1.5% and investing the proceeds in agency debt. But some of the trillions of dollars currently being held by foreign central banks could definitely come in handy right now. They're sitting on nice capital gains on their Treasury holdings, thanks to the current flight to liquidity. It would be great if they started dumping those Treasuries and buying the bonds of Fannie and Freddie instead, at least for the time being.

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