China made a big impact on markets with the unexpected devaluation of their currency, the yuan. China has been a mixed bag this past year with their growth slowing substantially as they try and transition to a more consumer based economy. However, their investment markets have become more open, which yielded a sudden rush into China A-shares. The rally has been short lived and a good portion of the shares have fallen back down. The longer term issue is how long it will take the Chinese economy to settle into the new economic model. While domestic demand has been weak, exports are falling as well. Capital outflows are putting downward pressure on the yuan and it’s been up to China’s central bank to manage the situation. Here’s where it gets really interesting.
First, China would like the yuan to become part of a global basket of reserve currencies declared by the International Monetary Fund. But in order to get this endorsement, the Chinese government is going to have to let the yuan fluctuate in value more than it has in the past. The chart below shows how tight the trading range has been over the last few years until the recent devaluation.
A depreciating currency can help a country’s exporters, because it allows them to receive more of their home currency when they sell goods overseas, but China’s economy is massive. It’s unlikely that this one “adjustment” in the currency can alone stimulate the economy by boosting exports. So more capital outflows seem likely and the Chinese central bank will need to step in to support the currency. But why not just allow the yuan to tank to an equilibrium given the slower growth? A depreciating currency hurts domestic consumers by weakening their buying power, so that’s not a great idea if you’re looking to boost consumer demand. Further, to make the IMF cut, China would like the currency to be more market friendly and fluctuate accordingly…but within limits. Sharp volatility would likely hinder the chances of the yuan reaching reserve currency status. So, the Chinese central bank is left with the task to balance the yuan trading range by tapping into foreign currency reserves.
China has been growing foreign currency reserves DRAMATICALLY since the mid-1990s. This chart shows those reserves have suddenly started to fall in the last year. As China has started to slow, it appears the long accumulation of foreign reserves could be coming to an end as the Chinese bank needs them to manage exchange rate volatility.
So how does all this relate to Treasuries? Of the $3.69 Trillion in Chinese foreign reserves, roughly $1.3 Trillion of those reserves are in U.S. Treasuries. This makes China the largest holder of U.S. Treasuries in the world. If the Chinese central bank is starting to use reserves to manage further drops in the yuan, the U.S. Treasury market could have another huge seller step into the market along with the Fed as interest rates begin to rise.
Now the Federal Reserve may have a little more leeway to hold what they have on the books to moderate a sell-off in Treasuries. This is all assuming U.S. inflation expectations stay benign. Yet, wages here at home are finally starting to go up, retail numbers are looking better, and unemployment continues to tighten. If inflation worries start to pick up, the Fed may be forced to take some type of action sooner than later.
In my opinion, all of this suggests further risks to the Treasury market and could suggest more volatility in the future as these trends develop.
– Charles Freeman, CFA
Saft, James – Global Axis shifts as China reserves dwindle – Thomson Reuters – August 11, 2015
Bloomberg – Yuan Devalued to Combat China Slowdown – August 11, 2015
Wei, Lingling – Keeping Yuan Stable Hit’s China’s Currency Reserves – April 14, 2015