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Why China's Liquidity Crisis Could Lead to a Perfect Storm in the US Bond Market

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QE tapering is changing the dynamic between the US dollar and the Chinese yuan. Here's where the shift could take us.

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India has raised interest rates. China has lowered them. Brazil is selling dollars. Japan is buying them.

Back on July 17 in Bloomberg's Economics Brief, Pierpont Securities Global Strategist Robert Sinche (formerly RBS's FX strategist) wrote a commentary about the spread between spot CNY and the non-deliverable forward that was signaling yuan depreciation.

Over recent weeks, the difference between the current spot dollar-yuan and the 12-month non-deliverable forward rate has hovered near its widest since flexibility was announced in 2005, save for a period of extreme market turmoil in late 2008. Over recent weeks the 12-month NDF has regularly discounted about a 2% depreciation of the yuan against the dollar over the next year.

There appear to be two main factors behind the shift in market expectations favoring a yuan depreciation. The first is fairly straightforward: a widening interest rate differential that, according to pricing of the forward market, implies a weakening yuan.

CNY Vs. NDF



You can see that, up until 2012, the NDF consistently discounted a strengthening yuan (lower CNY). However, when the Fed opted for a balance-sheet neutral Operation Twist in the fall of 2011, it had a direct impact on China FX reserves, the forward value of the CNY, and in turn, their purchases of US Treasuries. Between September 2011 and 2012, China FX reserves barely grew, and their ownership of USTs dropped. Conversely when QE III was launched in 2012 China FX reserves increased and they picked back up their purchases of Treasuries.

China FX Reserves Vs. Fed Treasury Balance Sheet



As BAML suggests, the excess liquidity provided by LSAP is the fuel to the Chinese economy, and in turn, their cash created to finance our debt. The more the Fed buys, the more China buys. However, if the Fed is about to turn off the spigot, then China is going to need to find liquidity from someplace else. As the NDF suggests, that may be a weaker yuan.

Since China entered the WTO in 2001, the exchange rate situation has been one-way. The yuan is pegged to the dollar, and this subsidizes US import demand to the benefit of the Chinese export economy. The Chinese finance this consumption by purchasing our debt with dollars we export. This relationship worked pretty well up until the US financial crisis.

Since, the financial crisis GDP growth has been tepid and US consumption has waned. The rate of growth of personal consumption expenditures is now at 2.9% near the lowest in 50 years. This is a problem for export-driven economies because US consumers (namely, the baby boomers) are reducing consumption, which means reduced dollars imported into China. The implied strength in the CNY was a product of the USD import, but with fewer dollars flowing into China, that exchange-rate advantage weakens. Up until now, QE has made up the difference, but tapering is changing this dynamic. This could be another reason forwards are pricing in a weaker CNY.

Why should US investors care?

The Next Market Accident

The US largely externally finances its debt with foreigners owning roughly half of Treasuries outstanding. In September 2001, when China officially joined the WTO, they owned just $72 billion of the total $2.9 trillion in marketable outstanding US Treasury debt (2.5%). As a comparison, at that time Japan owned $300 billion. In July 2005 when they introduced the band to the CNY peg, China was up to $300 billion of $4.0 trillion (7.5%). Today China is the second largest holder behind the Federal Reserve and owns $1.3 trillion of the $11.3 trillion in marketable debt outstanding (11%).

Japan is the third largest holder of Treasuries, but since Abenomics began, the Japanese have curtailed their purchases of Treasuries. At the end of 2012, Japan owned $1.11 trillion, and as of May 2013 they still owned $1.11 trillion. Presumably Japan will continue to depreciate the yen, which means we should expect their appetite for Treasuries to continue to wane.

JPY Vs. Real 5-Year Yield



It's not a coincidence that dollar asset demand is a function of the world's reserve currency value. It's purchasing power. The more USDs were exported around the world, the more purchasing power foreign currencies gained. For the past decade the JPY has appreciated against the USD, and the Japanese have been a big sponsor of our debt. This is why the USDJPY is so correlated with real interest rates. But with USD strengthening on the back of a rise in real interest rates, is that demand for US dollar assets about to change? You can see how there is a big feedback loop in play here. The higher real rates rise, the stronger the dollar becomes, which reduces foreign purchasing power for USD assets, which pushes rates higher.

When my bank's management asks me what I think about the bond market and the future trajectory of interest rates, I always tell them what I think is going to happen based on fundamentals and then why it may not work out that way. My stock answer to the latter is that I worry about "accident" risk. By accident I mean a fat-tail event that is out of our (the Fed's) control and unrelated to economic fundamentals. The next accident could be the result of fallout from a float of the CNY because there is no way to handicap what that might mean for USD asset prices.

If you want to know what can go wrong, this is it. The PBOC floats CNY, which depreciates against the USD, providing China with less purchasing power with which to buy US debt. With the Fed ending tapering while both Japan and China devalue, you could potentially see the three largest purchasers of US Treasuries all pulling back from the market at the same time. It would be naive to assume that that would not elicit a severe reaction in the US bond market. In fact, it may already be happening.

Twitter: @exantefactor
No positions in stocks mentioned.
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