Why Yellen Won’t Be Gellin’

Anyone who thinks that Janet Yellen will be unabashedly bullish in her assessment of the U.S. economy this week, better think twice.

The Fed chair will offer her semi-annual testimony in front of Congress this week, and she will most likely be guarded in her comments about monetary policy, but not for the reasons most investors think.

Recent U.S. economic data has been modestly positive, but hardly torrid. Consumer sentiment reached multi-year highs in the post-election euphoria, but it has since soured as the cold, hard reality of governing settles in. Job growth remains impressive, but wage growth does not and retail demand is still soft. This Wednesday‘s U.S. retail sales are expected to rise by only 0.1% versus 0.6% the month prior.

But the tepid pace of U.S. growth is not the primary reason that Janet Yellen may be cautious in her testimony. Two recent stories from the financial press should put all investors on guard.

Bloomberg, this week, profiles China‘s “Zombie Province.” — Liaoning. It‘s full of more than 800 companies that are effectively bankrupt but continue to function through government largesse and bank credit.

The story of China‘s bad debt problem is as old as time. In fact, betting on the collapse of the Chinese economy has become known as the “widowmaker” trade because it has bankrupted so many hedge funds over the past few years when the collapse never came.

But financial crashes are not anticipated ahead of time. Complacency fools you. For a long time, nothing happens and then within days everything happens.

Liaoning province may well be ground zero for China‘s non-performing loan problem, and any collapse of liquidity could quickly snowball into a financial crisis.

Which brings me to the second story of concern … despite rising U.S. yields, foreigners are dumping U.S. debt.

Fed Chairman Janet Yellen has two reasons not to raise interest rates — China and Japan.

China, which owns just over $1 trillion of Treasuries, has been selling since May and its holdings are now at a seven-year low. More worrisome, Japan – which has long been one of the most loyal customers of U.S. debt – has pulled back as well. Japanese government bonds offer about one-tenth the yield of currency-hedged U.S. bond positions. But Japanese portfolio managers are reluctant to jump into the American market. The Japanese have reduced their exposure to the U.S. fixed-income market to their lowest level in four years. Fears over policy, fiscal spending and political instability undermine the attractiveness of U.S. yields.

None of this poses a serious problem for U.S. debt financing. The Fed after all could easily monetize whatever the Treasury offers, but therein lies the rub. If U.S. rates rise, the Fed‘s job will become much harder and more expensive.

Therefore, Ms. Yellen is likely to offer only cautious guidance on rates in her testimony to Congress and to stick to the gradualist approach. That means that the next rate hike will not come until June at the earliest, which is likely to put a cap on any rally in the dollar and U.S. yields as the Fed takes it nice and slow.

FYI, Yellen’s report is just one type of event that can trigger investment opportunities for members of Calendar Profits Trader, a forex-trading service I handle with my partner Kathy Lien.

Happy Trading,

Boris