The yield on Chinese bonds are inverting at an accelerating rate. This does not portend well for the Chinese economy, and this may have negative implications globally.

 An inversion of the yield curve occurs when short-term interest rates are higher than long-term interest rates. 

 Typically, the opposite occurs, since long-term investments are associated with more risk. Additional risk, such as price inflation, currency depreciation, default, and lost opportunities, cause investors to demand higher rates of return for longer-term investments.

An inversion of the yield curve is usually the result of an anticipated slowing of future economic activity over the coming year or two. This anticipation is reflected in lower demand for short-term corporate debt, which simultaneously depresses prices and increases rates for this debt.

In addition, this prognostication is followed by decreased demand for corporate equities based on unfavorable business conditions and lower profit potential in the near term (one to two years).

 The China yield curve, which has been inverted for nearly six months, continues to move in this direction with greater velocity.

 The Shanghai Interbank Offer Rate (SHIBOR) is the short-term rate of interest that Chinese banks are willing to lend other Chinese banks. The current rates for one week, one month, three months, one year, and 10 years are: 9 percent, 8 percent, 6 percent, 5 percent, and 4 percent, respectively.

 Note: The longer the term, the lower the rate.

 In the past 50 years, this indicator correctly predicted all but one economic slowdown.

The identical scenario occurred in the U.S. in February 2007 prior to the financial crisis. At that time, the yield for the two-year Treasury note was 4.93 percent, while that for the 10-year Treasury bond was 4.81 percent.

The National Bureau of Economic Research (NBER) determined the economic recession began in December 2007, 10 months later.

 The reason for the Chinese yield inversion: the currency exchange rate mechanism

Since 1980, China has purposely devalued its currency (yuan) to increase the demand for its export products. When the Chinese yuan devalues, the yuan is equivalent to less foreign currency. Therefore, an export product priced in yuan requires less foreign currency, which translates into more demand for Chinese exports.

In 1980, the U.S. dollar purchased 1.50 yuan. By 1994, it purchased 8.46 yuan. Today, the rate is 6.50.

The Chinese do not allow the market to adjust the currency exchange rate: it is determined by government policy. The low relative value of the yuan has increased demand for Chinese products tremendously. This has created a huge demand for yuan and an inflow of foreign currency reserves (approximately $3 trillion).

 The increase in demand would typically increase the value of the yuan, bringing supply and demand into equilibrium. Since, the currency exchange rate remains fixed, demand for yuan exceeds supply. Therefore, the Chinese create yuan to satisfy the demand.

Wu Xiaoling, vice chairman of the Financial and Economic Affairs Committee of China's National People's Congress, recently said, "In the past 30 years, we have used excessive money supply to rapidly advance our economy."

China has the highest ratio of broad money (M)-to-income (GDP) in the world. This suggests there is an excess of money and a lack of transaction velocity (V), since GDP = M times V.

During the past decade, the broad money stock in China increased nearly 20 percent per annum, while real GDP grew at 10 percent per annum. In the U.S., money and income growth per annum were only 5 percent and 3 percent, respectively.

The large quantity of money has created an increase in demand for many asset classes, including land, housing, and commodities. The result has been an increase in asset prices. urrently, annual inflation is approaching 5 percent.

Inflation and inflationary expectations portend future uncertainties and risk. This unfavorable climate reduces demand for foreign and domestic investment as well as domestic exports. 

To combat inflation, China is attempting to reduce the quantity of money available by increasing interest rates and required bank reserves (20 percent of deposits). The former restricts demand for loans, while the latter restricts supply of loans.

Ironically, further threatening growth and income are the downward price pressures on commercial and residential real estate. The former has excess supply and the latter has deficient demand

Price depreciation of these assets will likely dampen collateral values and reduce the supply and demand for loan and credit activity. This suggests a reduction in economic activity and income.

These dynamics indicate an economic slowing in the near term (one to two years) as money is removed from the system. The business environment may be less profitable, which may depress equity prices in the near term as well (one to two years).

This may have negative implications globally as well.

As excess money is removed from the Chinese system, velocity will increase, permitting more stable, long-term income growth.