How Chinese Buying Could Render the Fed's QE Taper Moot
China could move away from supporting the euro and begin buying US Treasuries, thereby providing a cushion against the impact of a shift in Fed policy.
I noticed this first after the yuan revaluation stopped cold in its tracks after the July 2008 backstopping of Fannie Mae and Freddie Mac. Chinese officials were stunned to learn their holdings of the mortgage giants did not carry the full faith and credit of the Treasury. A deal was struck, apparently, to backstop these holdings in exchange for an end of revaluation. Other deals have come and gone involving a trade-off between Federal Reserve quantitative easing and Chinese purchases: They will support our debt in exchange for an end to revaluation when the Federal Reserve ceases to finance the Treasury. Of course, the Federal Reserve has found it difficult to stop talking monetarily and let someone else get a word in edgewise.
Switch From Euro
If the FOMC decides to start tapering its purchases in September, something it almost has to do given the lower issuance of Treasuries and the generation of mortgage-backed securities regardless of the macroeconomic data, China could switch from supporting the euro as it has since Mario Draghi’s July 2012 “whatever it takes” declaration. This is not a far-fetched notion at all: If we map the excess carry returns from borrowing the dollar and euro and lending into the yuan, we see a strong break at the end of July 2012. The yuan started to strengthen against the dollar but actually has weakened against the euro. Implied here has been Chinese support of Europe’s bedraggled sovereign debtors.
Response to FOMC Backtracking
Next, let’s take a look at how the volatility of three-month yuan forwards collapsed after the June 24 mea culpas from FOMC officials about ending QE. The sharp decline in volatility suggests a great deal of acceptance of its accelerated rise. Once again, the implied deal was that the Federal Reserve would keep on supporting China’s portfolio investment, per 2008, but this time the US would use its debtor leverage to have China keep revaluing the yuan. Please note how abruptly interbank lending conditions in Shanghai changed on this date; the yield curve as measured by the forward rate ratio between six and nine months flattened immediately as a way of boosting the yuan.
The stage is now set: If the Federal Reserve starts its taper at last and China’s portfolio holdings are threatened, China can step into the breach and start buying Treasuries instead of various eurozone bonds. The euro will weaken, the dollar will stop declining against the yuan, and the net effect of the taper on US financial markets will be cushioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.