Fear Not the Yuan: Chinese Markets Not Affecting US Treasuries

Howard Simons
  MAR 26, 2014 12:15 PM

Study the relationship between long-term Treasuries and Chinese equities and you'll realize it's not as worrisome as some might think.


One of the downsides of market globalization and interconnectedness is we are trained to believe every hiccup here has an effect there. When our good friends at the People's Bank of China ended the one-way bet on yuan appreciation last month, I received a number of worried inquiries as to whether this was a sign of impending doom or even worse. (Side note: People's Bank of China is such a cool name. I think Goldman Sachs (NYSE:GS) should change its name to the People's Bank of Lower Manhattan and invite Bill de Blasio over to unveil the new plaque.)
No worries, mates. Those concerns should be reserved for currencies such as the Japanese yen, Swiss franc, and US dollar, which are used to fund carry trades -- and they're concerns that should arise only when those funding currencies start to appreciate unexpectedly. As the yuan is not a funding currency, and as it has weakened, not strengthened, we won't see the usual round of emerging market shellacking normally reserved for such occasions.
US Treasuries

What, then, about the relationship between Chinese markets and US Treasuries? Let's take a look at the returns for seven- to 10-year Treasuries as a function of Chinese equities' long march to nowhere over the past 6.5 years and against the excess carry return in the implicit carry trade for a yuan-domiciled investor lending money to Uncle Sam.
The total return on the MSCI-Barra China Free index in CNY terms is at August 2007 levels; this was the time when both the Federal Reserve and European Central Bank began their long series of financial market interventions. US Treasuries have returned 50% over this same period.  While their correlation of returns has been negative, this is simply a statistical artifact of two unrelated markets moving in different directions; there is no causation in either direction.

We can arrive at a similar conclusion for the yuan and Treasuries. Treasuries have returned 0.93% since tapering was postponed in September 2013; this qualifies for a pretty flat return in my book. The CNY:USD excess carry return between then and the yuan's peak in February was 1.69%; it lost 2.62% thereafter. Treasury returns across these two yuan periods were equivalent to each other at an 88%+ confidence level.  Restated, whatever the yuan did in either direction was fine with Treasuries.

Finally, if China continues in a weak-yuan policy, it will have to execute it via monetary accommodation. The end result, as noted earlier this month, will be a flow into either USD- or EUR-denominated assets; this will offset the Federal Reserve's actions in tapering QE and will be bullish for financial markets. Whether such a policy will be effective macroeconomically is another matter altogether. 
No positions in stocks mentioned.