Shanghai Composite Hits Lowest Level Since May

China's Shanghai Composite index got walloped overnight - falling 6.7% - and reaching it's lowest levels since May, reports the Wall Street Journal.

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Could China be leading the broader markets down? I think it's very possible. China's been the posterchild of this monster rally - "Look everyone, China's doing OK!" And if China's not really doing so hot...uh oh!

In reality I think we've seen a lot of smoke and mirrors from a government desperate to keep the economy rolling. They've used enough forms of "economic steroids" to make a MLB slugger proud.

With Chinese stocks off nearly 25% since August 4th, I'd be very cautious right now about equities in general.

Related reading:

• How China Goosed Intel's Q2 Numbers
• Jim Rogers: I Would Not Be Buying Chinese Shares Right Now

China to Stick With US Bonds - or Will They?

Earlier this week, Chinese officials commented that they will continue to buy US Treasury bonds, because they have no other viable vehicles to park their cash.

From the Financial Times:

Luo Ping, speaking at the Global Association of Risk Management’s 10th Annual Risk Management Convention, said: “Except for US Treasuries, what can you hold?” he asked. “Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option.”

Mr Luo, whose English tends toward the colloquial, added: “We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

Are Mr Luo's comments to be taken at face value?

Or is it possible that he is giving the US, and the rest of the world, a head fake, as the Chinese quietly diversify away from US Treasuries?

China Starting to Regurgitate US Debt

The New York Times reports: China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.

I have no doubt, Dear Reader, that you're way out in front of this story, which is finally hitting the mainstream outlets. I mean c'mon - we've believed that Chinese demand for US debt was likely to slow for months.

Unfortunately positioning ourselves in front of this trend hasn't been a profitable move - at least yet. The 10-Year Treasury Note continues to hold strong, just below historic highs.

Chinese Bailout May Send US Interest Rates Higher

Over the weekend, China announced a $586 billion "stimulus plan" for its slowing economy.

China is in a precarious position as the world economy grinds to a halt. Out of it's 1.3 billion people, most have not participated in the economic boom the greater country has experienced.

Let me know if this sounds familiar - the rich have gotten richer, while the poor have stayed, well, relatively poor. As a side note, you can see there is nothing unique, wrong, or evil about this phenomenon that has taken place in the US. It's the way of nature - the greater the progress, the more of a gap that develops between the haves and have nots - a topic we could explore at great length in and of itself.

Back to China - the majority of the population still lives in the countryside, and the majority of the population is still poor. And they do not like seeing their fellow countrymen get rich without their fair share (sound familiar again?)

To this point, the Chinese government has been able to pacify the masses with sufficient government bread and circuses, as long as the economy continues to hum. But the Chinese state, as currently constituted, may not be able to survive a deep recession, at least without a potential revolution from its countryside.

Historically, most Chinese uprisings originate from the countryside. Expect the Chinese government to do whatever is necessary to prevent a severe slowdown. They must establish domestic demand for their products and stop relying on exports, and they must do it soon.

I think they'll be able to hold things together. Unlike the US, the balance sheet of China (both consumers and the greater government) is quite plush right now. The Chinese save a lot of their money, and they have sufficient capital to get through this - not to mention if/when they really catch on to credit cards, which we saw evidence of earlier this summer.

So what does this all have to do with interest rates in the US? The Chinese government will have less money to stash in US Treasuries - which will put a significant dent in the demand for US Treasuries - which should send rates up, up, and up.

And how about the supply side of the equation? Looks like that's about to skyrocket also. From Bloomberg: "The US government's borrowing needs will almost double to $2 trillion this fiscal year, prompting the Treasury to revive three-year notes and hold more frequent sales of 10- and 30-year debt."

Add these to reasons that I previously outlined, and it appears we have a recipe for skyrocketing long term interest rates.

How can you participate in this trade? I'd suggest looking at the ETF TBT, which was suggested by several of our readers here, and probably the easiest way to short long-dated treasuries. By buying TBT, you are essentially placing a leveraged short on long-dated treasuries.

TLT is another potential play - it's the inverse of TBT, so you'd want to short it. For what it's worth, legendary trader Dennis Gartman said he prefers a long TBT position to a short TLT position.