BURIED UNDER THE HEADLINES
2017-06-06 5pm EDT | #China #bonds #Raoul Pal #CNY #macronomics
This morning’s big news is the Chinese announcement they would they would buy more US Treasuries as the Yuan stabilizes. From Bloomberg:
China is prepared to increase its holdings of U.S. Treasuries under the right circumstances, as officials judge the assets are becoming more attractive than other sovereign debt and as the yuan stabilizes, according to people familiar with the matter. Treasuries rose, driving yields to the lowest since November.
The people didn’t specify the exact circumstances for continuing a run of purchases that has extended to two months through March, after reductions in all but one of the previous eight months. The nation has maintained the trend, said the people, who asked not to be identified because they aren’t authorized to comment on the matter publicly. The yuan has climbed more than 2 percent against the dollar this year, after plunging 6.5 percent in 2016 in its biggest decline in more than two decades.
While China reduced its ownership of Treasuries last year by the most in data going back to 2000 as it sought to defend the yuan, it has since changed strategy and added to its holdings in the two months through March.
Although the knee jerk market response was to take US Treasuries higher, I wonder if traders are misinterpreting the news.
If China’s intention was to buy US Treasuries because they are cheap versus other countries’ fixed income (something I agree with), why on earth would they announce their plans ahead of time? There is only one answer - the Chinese have ulterior motives. The question is, what are they?
Many market participants were quick to point out that China has already changed policy. Zerohedge highlighted the fact that over the past quarter, China has actually been increasing their US Treasury holdings.
Although some cynics might argue China is talking up treasuries so they can sell their position, I don’t buy that. China has bigger fish to fry than engaging in short term US Treasury price manipulation simply to flip a few bonds.
Yet, they definitely have an agenda, so what is it?
I think this has more to do with the currency than the bond market. Last year, contrary to the narrative Trump and his crew were touting, the Yuan was too expensive, and Chinese authorities faced huge outflows. This is obvious in the above chart with both FX Reserves and US Treasury balances experiencing big ugly down bars between July and November. The Yuan’s value is difficult to measure because it is not traded solely against the US dollar, but also a whole host of other currencies. So it might have been too high versus the US dollar, but too low versus European countries. Or the other way round. When you have a managed currency, it is more difficult to find a level at which flows are balanced.
There is no doubt that Chinese citizens believe the Yuan is too high. Whether it be Sydney or Vancouver real estate, bitcoin, or even foreign companies, Chinese individuals are desperately trying to diversify their wealth out of Yuan, and into other currencies.
The Chinese authorities realize the problem, and have tightened capital controls in an attempt to staunch the outflows. But that’s not a long term solution, and the Chinese realize the Yuan needs to be devalued lower.
The real problem was a matter of timing. Devaluing during a US election wouldn’t have been wise. And now that Trump is in the White House, it seems like the chances of a lower Yuan without increased US pushback has only decreased.
Yet what if Xi’s meeting a couple months back with Trump resulted in a deal? What if the two leaders agreed China would invest in US infrastructure, help out with North Korea, and in return, the US would allow China to devalue their currency?
If you were to “sell” a devaluation, then it makes sense to frame it not as a lowering of your currency, but instead as an investment in the other country’s bonds. After all, if China were to devalue, they would be forced to sell Yuan and buy US dollars. With those US dollars, they would be buying treasuries. So by saying that China might invest in more US Treasuries is akin to saying, “we might devalue.”
Last month, the highly respected macro strategist Raoul Pal expressed a view that a Chinese Yuan devaluation was imminent.
Unfortunately, instead of devaluing, the Chinese government squeezed the shorts. The Peoples Bank of China cranked short rates, and caused the USD/CNY rate to decline (higher Yuan) from 6.90 to 6.78.
I contend that Raoul was not wrong, but merely early (some might say that’s as good as wrong, but this game is difficult enough without having to time everything perfectly). The PBoC does not want this devaluation to be a one way street where speculators easily earn profits. Keeping everyone honest by strengthening the Yuan right ahead of a devalue seems perfectly logical to me.
I believe the Chinese purposely tightened last year so that they could ease into this Autumn’s People’s Congress (China Downgrade - buy the news?). After writing that piece, a great macro writer by the name of Martin Tixier, who pens the terrific Macronomics blog, wrote me to say, China is conducting a “controlled demolition of their WMPs (wealth management products).” What an awesome line. And I couldn’t agree more. Their tightening was designed to take some steam out of the frothy areas of their economy.
But now they have tightened enough. They have slowed their economy. Withdrawn liquidity out the global financial system. They have accomplished what they set out to do.
From here on out, the emphasis will center back on creating the growth that is necessary for the government’s survival. Today’s development of the Chinese potentially buying more US Treasuries, only reaffirms my belief that there will be a Chinese 3rd quarter reflating of the global economy.
I am not sure if you should get long US Treasuries because the Chinese have indicated that they might buy some more. But I do know that you shouldn’t short world growth because China is about to implode. I suspect we have seen the last of their tightening policies, and that Raoul and all the other Yuan bears, might just be right yet. As usual, the real trade is buried under the headlines.
Thanks for reading,