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IS CHINA CAREENING TOWARDS FINANCIAL CRISIS?

Takeaway: Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.

SUMMARY BULLETS:

 

  • We believe that China has a fair amount of systemic risk built up across its financial sector; in the note below, we walk through the key risks, potentially adverse outcomes and how Chinese officials have responded to them in previous iterations, as well as how they may respond to them in the future. It should be noted that the aforementioned risks are reasonably offset by the political will and fiscal firepower needed to avoid a systemic collapse.
  • As we penned in our 3/13 note titled, “CHINA’S IN NO MAN’S LAND”, the fundamental outlook for both the Chinese economy and the Chinese equity market is now particularly uncertain – especially in light of the risks embedded in China’s shadow banking market. In confusing times like these – particularly when the data is either sparse or misleading – we defer to our quantitative risk management signals for guidance. On that note:
  • BUY [more] on a breakout above TRADE resistance (2,298): A probable sequential pickup in MAR growth data and a probable sequential slowing in MAR inflation data supports this action. Moreover, continued USD strength (and, by association, CNY strength) should weigh on int’l raw materials prices and allow the pace of economic activity to creep higher in China, as China’s heavy industry needs energy and raw material deflation to produce more with less credit expansion and the Chinese consumer needs food deflation to consume more discretionary goods and services.
  • SELL on a breakdown through TAIL support (2,306); SHORT China on a breakdown through TREND support (2,206): As we’ve seen since 2009, the pace of activity in the Chinese property market has become the #1 factor in determining growth rate of Chinese economy – via credit expansion – and the returns of Chinese financial markets. That quantitative signal would be a clear-cut sign that there is likely more policy-perpetuated pain to come in the months ahead – especially to the extent those linkages have not broken down as much as the CCP would’ve liked.
  • At any rate, we think it’s best to run full speed away from anyone who tells you they know exactly how this all ends and on what duration(s). China is quite possibly the largest and most unique economy (capital controls, state-capitalism, etc.) ever to have to undergo such meaningful financial reforms. There will be winners (i.e. Chinese consumers and SMEs), losers (i.e. Chinese property developers and marginal producers in oversupplied industries) and [many] unintended consequences that are, quite frankly, hard for even the best industry analysts to accurately predict at the current juncture.

 

THE RISKS

Earlier this week China Daily reported that the China's banking regulator has urged banks to pay close attention to the credit risks in key industries affected by the economic downturn and hit by overcapacity woes. Zhang Ping, Chairman of the National Development and Reform Commission recently said that the industrial sectors suffering most from overcapacity include steel, cement, electrolytic aluminum, plate glass and coal coke sectors, each of which is operating at 70-75% of total capacity.

 

The aforementioned article also showed that analysts estimate the outstanding loan portfolio of those industries may amount to around 30T-40T yuan ($4.83T-$6.44T or 22.6-30.2% of total banking system assets at the end of JAN). Per the PBOC, outstanding loans to the property sector were 12.1T yuan at EOY ’12.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 1

 

In addition to these on-balance sheet risks, China has roughly 15T yuan of off-balance sheet credit (28.8% of GDP) in the form of commercial bills, trust financing, entrusted loans, etc. that has increasingly been allocated to riskier borrowers in recent years (per various agencies, including the IMF) – many of whom which have outsized exposure to property prices, such as property developers and local gov’t financing vehicles (LGFVs).

 

It’s worth noting that residential and commercial land prices did rise +2.3% YoY and +3.3% YoY, respectively, in 2012 and that Chinese real estate prices are increasing in multiples of those growth rates in recent months.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 13

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 14

 

The latter entity has 636.8B yuan in bonds outstanding as of EOY ’12 (+148% YoY) and 9.3T yuan of loans outstanding (17.9% of GDP) – 20% of which are “funding projects which are largely not profitable and thus are vulnerable to [repayment] risk,” per PBOC Governor Zhou Xiaochuan. Want China Times suggests as much as 53% of LGFV debt is set to mature in 2013, though it is widely expected that the bulk of loans facing repayment risk will continue to be rolled over. Liquidity delays insolvency.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 2

 

To the previous point regarding the growing exposure of China’s financial system to the country’s property market – which remains structurally underpinned by the confluence of financial repression and a closed capital account – both Chinese banks and large cities (Guangdong, Shenzhen) have recently begun to implement the latest round of nationwide property curbs, which, as we penned on 3/1, were more severe and announced far sooner than we had anticipated.

 

HISTORICAL PRECEDENT

While we’re not in the camp that believes China’s financial system is careening towards crisis, we’d be remiss to ignore the risks associated with rapid credit expansion coupled with an increasing overreliance upon pooled capital largely feeding into collateralized property market exposure. If this sounds familiar, it should; the major difference between the US and Chinese experiences, however, is that Chinese officials are well aware of these risks ahead of time and continue to implement a series of macroprudential measures designed to mitigate them in a proactive manner (vs. being fast asleep at the wheel like Greenspan and Bernanke were).  

 

From a corporate perspective, Bloomberg data shows the average debt/EBITDA ratio of Chinese non-financial corporations has nearly doubled to 4.1x from 2.2x over the last five years. Per Liu Yuhi, Director of the Financial Lab at the Chinese Academy of Social Sciences: “Although financing activities in the country appear to be rampant, most of the newly borrowed money is used to repay debts instead of forming revenue among companies.” The value of LGFV loans that matured last year was 1.9T yuan, with about 86.7% repaid on time.

 

Indeed, a great deal of recent credit expansion has been simply to roll over existing loans and, while that mitigates the risk of a potentially-destabilizing near-term acceleration in NPLs, it does come at the direct expense of Chinese economic growth – which we have contended and continue to believe will remain rather subdued relative to prior cycles (see: 13-straight weeks of steel product inventory increases as of MAR 10th).

 

SHORT-CYCLE OUTLOOK

It’s a reasonable assumption that China’s fixed asset investment-driven economy (China’s “I”/GDP ratio is roughly 1,000bps too high per the IMF) may indeed experience a major financial shock followed by a prolonged economic downturn when it’s all said and done. That said, however, as long as the CNY continues to make a series of higher-highs on a ~19 year basis and the SHCOMP remains in a Bullish Formation, we think it pays to ignore those risks for now and bet on a continued cyclical upswing in the Chinese stock market(s).

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 3

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 4

 

Because of China’s crawling currency peg, Strong Dollar = Strong CNY (for the most part, absent heavy PBOC intervention) and that ultimately equates to declining CPI and PPI figures on a lag (see: yesterday’s preannounced gasoline and diesel price cuts of CNY 0.23 per liter and CNY 0.26 per liter, respectively, and the NDRC’s aggressive denial of a market rumor natural gas prices would be hiked in APR).

 

That should ultimately equate to a higher velocity of money in China over the intermediate term, given the State-imposed targets for monetary expansion (2013 M2 Target of +13% YoY, down from +13.8% in 2012; 2013 New Loan target of 9T yuan, up from 8.2T in 2012). CNY strength predicated on inflows of foreign capital (see: latest FDI and Foreign Deposits data, which were up +6.3% YoY and +4.1% YoY, respectively) should help offset the PBOC’s increased hawkishness, at the margin.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 5

 

All told, we still think that the risk is to the upside in Chinese equities over the intermediate-term TREND; refer to the section below titled, “PARTING THOUGHTS” for more details. From a long-term TAIL perspective, the beta risk is truly anyone’s best guess. Elements of systemic risk are indeed present across China’s financial sector – but so is the political will and fiscal firepower needed to avoid a systemic collapse.

 

LONG-TERM OUTLOOK

We’ve come across several analyses that suggest that adding in all “contingent liabilities” would increase China’s sovereign debt/GDP ratio to north of ~90% (vs. an official ratio of 22.2%), thus limiting its ability to respond to any potential financial crisis with fiscal measures. That does, however, compare rather handsomely with our estimate of a ~450-500% ratio for the US gov’t in 2012 when we last completed the analysis back in a late-2010 presentation on the US’s fiscal outlook. Consensus storytelling has a bad habit of ignoring counterfactual evidence.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 6

 

Imagine if the Treasury/Fed didn’t let Bear Sterns or Lehman Bros. fail and the federal balance sheet had enough borrowing capacity to actually afford what many consider to have been largely wasteful “stimulus” measures and “defense” spending. We’d be willing to bet that the last five years of domestic economic conditions would have looked remarkably different relative to the sluggish pace(s) of activity and growth scares we’ve become accustomed to… that’s China’s opportunity in a nutshell.

 

At any rate, timing, as always, will be critical – as will the Politburo’s policy response. Will the Chinese Communist Party be proactive or reactive in dealing with these risks? That remains the key question for investors to consider; and, at these prices, we think it pays to bet on the former – of course pending further data! In the spirit of being proactive, the China Banking Regulatory Commission (CBRC) has assigned “preventing financial risks” as its top priority for 2013.

 

STRUCTURAL CHANGES AHEAD

As it relates to the PBOC’s role in the aforementioned agenda, there was some very important news announced yesterday in the arena of financial market reform. It was reported that new Premier Li Keqiang – among China’s most reformed-minded officials – will pursue incremental reforms in the form of further interest rate and/or exchange rate liberalization in the calendar year 2013.

 

As an aside, we think Li’s reform agenda is one of the primary reasons current PBOC Governor Zhou Xiaochuan retained his role after rounds of speculation that he would be replaced – potentially by Xiao Gang, Chairman of the Bank of China, and now a candidate for the top job at the China Securities Regulatory Commission (CSRC).

 

Under Zhou’s veteran watch, the PBOC may opt to relax or remove the cap on deposit rates, lower the floor on lending rates and/or widen the daily yuan trading band. This would build upon previous reforms in this general direction, as the PBOC, for the first time ever in 2012, permitted deposit rates as high as 110% of the benchmark. It also lowered the lending rate floor to 70% of the benchmark from 90% prior. As an aside, additional interest rate liberalization may put Chinese banks’ NIMs at risk of further compression. Additionally, the current +/- 1% margin around the PBOC’s reference rate was set back in APR ’12. 

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 7

 

INTENDED AND UNINTENDED CONSEQUENCES

The fact that these reforms are going to take place over the intermediate-term TREND vs. long-term TAIL is very, very interesting. On one hand, financial sector reforms will reduce the high burden of financial repression currently being levied upon Chinese households and SMEs, affording them better inflation-adjusted returns on their savings and far greater access to traditional bank credit, which is generally cheaper (in China) and more closely regulated.

 

That would be particularly positive for the expansion of China’s consumer sector and Chinese economic growth more broadly by supporting the Chinese Communist Party’s economic rebalancing agenda by allowing Chinese banks to take more risk via an increased allocation of capital to more productive and profitable enterprises than SOEs, which themselves perpetuate China’s overinvestment due to a systemic overreliance upon subsided credit and other heavily-subsidized factors of production to the tune of ~4% of GDP, per the latest IMF estimates.

 

On the other hand, better returns and improved access to credit for Chinese households and SMEs, respectively, may perpetuate an unwind of off-balance sheet lending activities, which, according to most sources, have been largely capitalized with the savings of China’s private sector that are seeking higher yields via Trust Products and Wealth Management Products (WMPs), where average annualized yields are 37% higher than the PBOC benchmark 1Y household deposit rate of 3%.

 

To the extent there are any weak hands in the WMP or trust financing space, a lack of new inflows, at the margins, would expose the “ponzi-scheme” nature of some products (per the words of the aforementioned Xiao Gang himself) – specifically those that rely on short-term funds in order to invest in long-term assets (including not-yet-profitable infrastructure projects or real estate) and fund distributions largely with net new inflows.

 

Because the bulk of this off-balance sheet lending activity is rather poorly regulated, it’s impossible to know the true size and scope of such at-risk institutions (i.e. any sell-side estimates you may have come across are likely closer to outright guesses rather than semi-accurate guesstimates).

 

China bears would have you believe that these types of at-risk loans comprise 100% of the ~15T yuan of estimated shadow financing; China bulls would have you believe that this type of highly speculative activity is confined to manageable, one-off cases like the city of Wenzhou – where more than 80 businessmen, unable to make payments on underground loans, committed suicide or declared bankruptcy in a six-month period last year.

 

REGULATORY RISK IS REAL

Today, the CBRC announced its first round of truly stringent regulation surrounding commercial bank’s involvement in the WMP market. Specifically, no more than 35% of a bank's WMPs or 4% of a bank’s total assets recorded in the previous fiscal year should be invested in debt that is not within the formal bond market. As an aside, debt outside “formal” bond market refers to credit assets, trust loans, entrusted loans, acceptance bills, letters of credit and account receivables that are not traded on the securities exchange or interbank market.

 

In addition to the aforementioned cap, and perhaps most importantly, the CBRC stated that commercial banks should not provide guarantees or make repurchase commitments to their WMPs. The latter regulation explicitly transfers the burden of repayment risk to depositors – many of whom may already be victims of moral hazard in the sense that they believe the banks will ensure their returns to the extent there are any defaults by the ultimate borrowers of the funds.

 

Currently the amount of banks’ outstanding WMPs stands at 8T yuan. Per the aforementioned cap, commercial banks can invest up to 2.8T yuan via their WMPs in debt outside the formal bond market – which is 1T yuan less than their current exposure!

 

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Ultimately, this rule should translate into slower (and potentially even negative) growth in the supply of credit within the shadow banking channel and to the extent any existing liabilities facing repayment risk aren’t able to be rolled over, we will start to see default rates accelerate across China’s shadow banking sector. Any spillover effects across key industries – particularly in the oversupplied construction and construction materials sectors – could adversely impact Chinese bank NPL ratios (currently at 0.95%) on a lag.

 

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IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 10

 

PARTING THOUGHTS

As we penned in our 3/13 note titled, “CHINA’S IN NO MAN’S LAND”, the fundamental outlook for both the Chinese economy and the Chinese equity market is now particularly uncertain – especially in light of the risks embedded in China’s shadow banking market. In confusing times like these – particularly when the data is either sparse or misleading – we defer to our quantitative risk management signals for guidance. On that note:

 

  • BUY [more] on a breakout above TRADE resistance (2,298): A probable sequential pickup in MAR growth data and a probable sequential slowing in MAR inflation data supports this action. Moreover, continued USD strength (and, by association, CNY strength) should weigh on int’l raw materials prices and allow the pace of economic activity to creep higher in China, as China’s heavy industry needs energy and raw material deflation to produce more with less credit expansion and the Chinese consumer needs food deflation to consume more discretionary goods and services.
  • SELL on a breakdown through TAIL support (2,236); SHORT China on a breakdown through TREND support (2,206): As we’ve seen since 2009, the pace of activity in the Chinese property market has become the #1 factor in determining growth rate of Chinese economy – via credit expansion – and the returns of Chinese financial markets. That quantitative signal would be a clear-cut sign that there is likely more policy-perpetuated pain to come in the months ahead – especially to the extent those linkages have not broken down as much as the CCP would’ve liked.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 11

 

At any rate, we think it’s best to run full speed away from anyone who tells you they know exactly how this all ends and on what duration(s). China is quite possibly the largest and most unique economy (capital controls, state-capitalism, etc.) ever to have to undergo such meaningful financial reforms. There will be winners (i.e. Chinese consumers and SMEs), losers (i.e. Chinese property developers and marginal producers in oversupplied industries) and [many] unintended consequences that are, quite frankly, hard for even the best industry analysts to accurately predict at the current juncture.

 

Happy Easter; enjoy the long weekend with your respective families.

 

Darius Dale

Senior Analyst

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - China SHCOMP


Nike, Under Armour and Sponsorship

Takeaway: Nike's $3.8 billion in sponsorship commitments is nearly 25 times those of Under Armour. Here's why that's important.

When you're the top brand with dominant market share like Nike (NKE), financial resources become a distinct competitive advantage.

 

In the chart below, company disclosures show that Nike has nearly $3.8 billion in sponsorships/endorsements on its books, which is 25 times higher than Under Armour (UA). That accounts for a far greater percentage of sales for Nike, too, as you can see in the chart below.

 

Nike, Under Armour and Sponsorship - sponsorship percentage of sales

 

Nike's financial obligations related to those sponsorships are also spread out over a longer time period compared to those of Under Armour, as this second chart shows. That's also a likely competitive advantage for Nike.

 

Nike, Under Armour and Sponsorship - Sponsorship Commitments


Still Bullish: SP500 Levels, Refreshed

Takeaway: Embrace crisis – the real crisis appears to be in crisis-calling itself.

POSITIONS: 14 LONGS, 7 SHORTS @Hedgeye

 

The all-time closing highs have been elusive, but that just gives Professional Top Callers (PTCs) more company. I can’t count how many people are trying to call the top at this point (and I can count).

 

The fulcrum point of our bull case on US Growth (#StrongDollar) remains not only intact, but improving by the week. This is the 7th week in the last 8 that the US Dollar Index is up wk-over-wk. And combined with both US employment and housing trends, we think that’s a pro-growth signal.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE overbought = 1569
  2. Immediate-term TRADE support = 1555
  3. Intermediate-term TREND support = 1494

 

In other words, both the US Dollar and the US Stock Market remain in what we call Bullish Formations (bullish TRADE, TREND, and TAIL) as our immediate-term Risk Range continues to signal higher-lows and higher-highs for the SP500.

 

Don’t buy at the overbought line. Buy them when they are red. Embrace crisis – the real crisis appears to be in crisis-calling itself.

 

Have a Happy Easter Weekend,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Still Bullish: SP500 Levels, Refreshed - MyChart


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INITIAL CLAIMS & GDP: CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE

Takeaway: No Surprises in the final 4Q12 GDP numbers. Initial Claims continue to improve although the rate of improvement slowed in the latest week.

GDP:  The Final GDP numbers for 4Q12 came in largely as expected with the final revision reflecting 0.4% growth for the quarter vs. expectations of +0.5% and against the preliminary and 1st  revision numbers of -0.1% and +0.1%, respectively.  A summary of the final numbers and revision impacts below.   

 

Revision Breakdown - All changes are vs. 1st Revision:

  • C (Consumption):  Contribution to Chg in GDP = revised down -19 bps;  Final Q/Q growth = +1.8%
  • I (Investment):  Contribution to Chg in GDP = revised higher by +37 bps.   Final Q/Q growth = +1.3%,   Residential Investment & Non-residential fixed investment Growth of 17.6% and 14.0%, respectively
  • G (Government):  Contribution to Chg in GDP = essentially flat, revised lower by -3 bps.   Final Q/Q growth = -7.0%
  • E (Net Exports): Contribution to Chg in GDP = revised higher by +9 bps. 
  • Inventories:  Change in Private Inventories revised +3 bps  
  • Real Final Sales (Demand for U.S. Products ex Inventory change): Final Q/Q Growth = +1.9%, revised +20 bps

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - GDP Summary 4Q12 Final 032812

 

 

INITIAL CLAIMS:  STILL IMPROVING, ALBEIT AT A SLIGHTLY LOWER RATE

Below is the detailed breakdown of the claims data from our head of Financials, Josh Steiner.  If you would like to setup a call with Josh or trial his research, please contact 

 

The good news is the labor market is still improving. The bad news is the rate of improvement isn't as strong as it had been. Rolling non-seasonally adjusted claims were lower YoY by 5.9% this week, as compared with 7.2% in the prior week. This rate of improvement is solid, but obviously a sequential deceleration. On a single week basis, the improvement slowed to -2.4%, down from -5.8% in the prior week. We place less emphasis on week to week moves as they've historically had significant volatility. The bottom line: the labor market is still improving, which is supportive for both credit quality and housing's momentum.

 

On the seasonally-adjusted side, the optical claims number was worse than expected rising 21k before revision to 357k. This brought the rolling SA print to 343.5k, an increase of 2.5k WoW. As this is what the market is paying attention to, it's logical that we're seeing the long end of the yield curve fall. This is incrementally bullish for housing, but obviously a continuation of headwinds on the margin. As a reminder, the SA data is now facing a small, but growing headwind over the coming six months. This headwind will peak in August 2013 and then turn into a tailwind for a final year. 

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 1

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 2

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 3

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 4

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 5

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 6 

 

INITIAL CLAIMS & GDP:  CLAIMS STILL IMPROVING, ALBEIT AT A SLOWER RATE - JS 7

 

 

Joshua Steiner, CFA

 

Christian B. Drake

 

 


How Many Corn Acres Get Planted This Year?

At noon today the USDA will issue its March planting intentions for the 2013 U.S. growing season.  We will focus on corn, as per usual.  Consensus calls for 97.465 million acres of corn to be planted this year, and we think there may be modest upside to that number.  That’s a big number, not an all time high, but it is the largest acreage that anyone that didn’t vote for FDR has seen.



Obviously, the yield is the key number going forward, and we think the soil moisture condition has shown some improvement in recent weeks, though still below where it should be for this time of the year.  However, the forecast is for some weather events over the next several weeks in a couple of regions where moisture is needed, so we remain encouraged.



However, one additional concern that we have beyond moisture at this point is that planting may be delayed – farmers don’t need to rush out and the ground is still too cold in many regions for planting to begin.  If the weather turns cold, early planted corn can rot as the re-frozen field melts and warms.

 

The good news is that planting can happen very quickly in the right conditions, so we aren’t all that worried if it appears that the crop is getting in the ground too slowly.

 

We continue to think that ADM represents an inexpensive look at the progress of the U.S. corn crop – we see downside in the name back toward book value ($29.05 per share).  Keep in mind, that as much as a disaster the U.S. corn crop was last year and the associated negative impact it had on ethanol and merchandise and handling margins at ADM, the company still managed to earn $2.25.  If things break “right” with the corn crop and incremental acres produce a “reasonable” yield (anything above 145 bushels per acre), we see upside in ADM toward $38/$39 per share.

 

How Many Corn Acres Get Planted This Year? - Corn Acreage

 

Call with questions,

 

Rob

 

Robert  Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

E:

P:

 

Matt Hedrick

Senior Analyst






A Telling Chart

Takeaway: Here's a very telling chart that looks at the relationship between the yield on the 10-year Treasury and weekly jobless claims.

Below you'll see a chart that shows the yield of the US Treasury since November, when Hedgeye made its growth call, and a rolling four-week average of the rate of decline of non-seasonally adjusted (NSA) jobless claims. (Note that we have inverted the 10-year yield curve to show the relationship between yields and NSA claims more clearly.)

 

What the chart shows is that as 10-year yields rise, the rate at which NSA claims decline also rises. In other words, improving jobless claims numbers and a rising 10-year yield are moving at similar rates and directions, which indicates overall economic growth.

 

A Telling Chart - 10Y vs NSA Claims  2


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