China and US Treasuries

The US Treasury market was consolidating yesterday's 7.5 basis point jump in 10-year yields when Bloomberg's headline hit.  The claim was that Chinese officials are "wary of Treasuries".  Yields rose quickly to test 2.60% and the dollar moved lower.  

It is difficult to determine the significance of the claim as the Bloomberg story does not quote anyone.  The "people familiar with the matter" who are cited are not identified, but claims that other officials who are reviewing the central bank's reserves, have recommended "slowing or halting" purchases of US Treasuries.   

The report clearly spooked the market, but it is worth looking closer at the issue to see the forces that are at work.  The first place to begin is the US Treasury market itself.  With above trend growth and a tax cut on top of it, many looked for higher yields (lower prices) this year.  The combination of less demand from the Federal Reserve, as its balance sheet shrinks by an accelerating pace from $30 bln in Q4 17 to $150 bln in Q4 18, and greater supply, other buyers will step up and it make take higher yields to incentivize.   

Speculators in the futures market are net short 10-year Treasury contracts for the first time since last April.   The switch is a function of gross long liquidation and accumulation of gross shorts.  The former appears to account for about 2/.3 of the recent net position shift.  Speculators have been short two-year Treasury note futures since last May. 

Also, we have been noting that the market-based inflation measures, like the difference between conventional yields and the inflation-protected securities (TIPS), have been rising.  The 10-year breakeven is holding now above 2%.  The two-year breakeven is 1.66%, which is an eight-month high.  

Investors are aware that US yields have been trending lower since the early 1980s.   The downtrend line appears to be coming in a little below 2.7% on the 10-year US yield.  Some asset managers have already called the end of the generation-long bull market, and of course some made the same call a year ago.  Others are waiting for some confirmation like a trend line to be violated.  

The second place to look is China. It reserves fell by about $1 trillion from the middle of 2014 through the start of last year.   The US TIC data shows that China's holdings of US Treasuries fell from about $1.27 trillion to about $1.05 trillion.   While China's reserves were falling, and it was paring its Treasury holdings, US yields continued to trend gradually lower.  That is to say, China's sales did not disrupt the market or spur a rise in yields. 

China introduced capital controls and the dollar depreciation last year saw the value of its reserves rise.  They rose by $129 bln in 2017.    The US TIC data suggests Chinese buyers may have bought a little more than $130 bln of US Treasuries through October (most recent data).  

China is a large and powerful country, but there are limits on what it can achieve.  It cannot rebuild its reserves and not buy foreign assets.  Remember the sovereign bond purchases by the ECB and BOJ absorb the net new issuance of their governments.  The US is the only major net new supplier of core sovereign bonds.  

Over the last several quarters, China has slowly allowed the allocation of its reserves to be including in the IMF COFER data.  As we tried to interpolate China's holdings, it appeared that its dollar holdings may have been a bit larger than average and their euro holdings a little lower than average.   There is scope for some mild adjustments in allocation of China's reserves.  However, to do so comes at a cost.  First, the US yield is 200+ basis points than Germany on 10-year borrowings.  Of to say the same thing, the US 10-year yield is roughly five-times higher than Germany's 10-year yield.  Japan's 10-year yield is 7.5 bp and is presently in a 10 bp +/- range on either side of zero, enforced by the BOJ.  

There may be another consideration: Politics.  The most pressing issue here is trade.  US President Trump talked aggressively about China during 2016 campaign, but in this here was very much part of what seems like what has become a tradition for the last couple decades or so.  However, also consistent with that tradition, upon assuming office, Trump did not back up the words with fresh action against China. China was not cited as a currency manipulator, for example, and the 25% tariff on Chinese goods that was suggested has not materialized. 

Arguably Year 2 of the Trump Administration could be different.  Trump did not get the kind of cooperation he sought from China in dealing with North Korea.  China's trade surplus with the US is growing.  Over the next week or two, the US Commerce Department must recommend whether or not to impose a tariff on steel and aluminum imports to protect US national security.  The threat is aimed at China, but other countries and producers could get snarled in such action.  

Later in the month, the Trump Administration is due to decide whether it wants to protect the US solar panel industry.  Also, possibly ahead of the Trump's State of the Union address (January 30), a decision may be made on retaliation for intellectual property rights violations, but the investigation that was launched last year may not be completed until later in the year.  

The Bloomberg account cited two considerations for the less supportive assessment of US Treasuries.  The first was that they may be less attractive than other assets.  Fair enough, but not just any asset will do.  It must be large, transparent and safe.  We recognize that on the margins, the PBOC could shift the allocation of its reserves.  This would likely be a gradual process, and if history is any guide, probably wouldn't have much market impact.  

The second consideration is trade.  The news wire story did not elaborate on this point.  We suspect, if that account is truly representative of important opinion in China, that it is a proverbial shot across the bow to warn the American First administration.   It cannot simply ride roughshod over others.  Still, in the recent past, China has shown an ability to decouple political considerations from its reserve management. 

Yesterday, China announced a change in the way its sets the daily reference rate.  We do not see a connection between that decision and the Bloomberg report today, suggesting that some officials are concerned about China's Treasury holdings.   The dropping of the "counter-cyclical factor" would seem to give market forces greater sway in setting in the yuan's reference rate, but China's embrace of market forces seems more opportunistic (when it agrees with the direction the market is moving) than an ideological commitment.   

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