The world is more interconnected than it has ever been. Over the past few years, the Chair of the US Federal Reserve has increasingly mentioned international factors that have limited further rate hikes, despite domestic data proving to be relatively strong. So, what exactly are these limiting factors?
The ‘Bond Vigilantes’ are an unknown group of investors who punish governments for not implementing certain reforms, causing yields on their sovereign debt to rise. But these Banksy-style investors are really just code for China. President Trump has gone out of his way to accuse the Chinese of artificially keeping their currency cheap, which republicans say has taken away jobs from Ohio, Michigan and Carolina.
What he does not seem to realise is that it is not wholly in China’s interest to have a depreciating currency, not least because importing becomes fiercely expensive; just ask Britain. In recent times, because the US has been the leader of global growth, market expectations have created a strong dollar. Due to the semi-peg between the dollar and the renminbi, the Chinese have been forced to run a strong exchange rate, creating a headwind for their export market.
In fact, despite Trump’s accusations, the Chinese want the yuan to appreciate, which is why they have been intervening in the market by selling a good amount of their own foreign reserves. When they sell foreign currency, it causes a decline in overseas rates, which in turn causes the yuan to rise. The People’s Bank of China (the Chinese central bank) has already sold $1trn in reserves since mid-2014, with just under $3trn now left in the pot.
The US Debt Issue
Another reason not to go around labelling China as manipulators are their holdings of US debt. The US Treasury department recently published figures for November last year of the moves in bond holdings from month to month.
Just a few years ago, overseas holdings of US Treasuries stood at $3.8trn. This is now just over $3.4trn. Appetite is declining, rapidly. In November alone, overseas holdings fell by $71bn and $66bn of that was China. In fact, that was China’s largest offload since 2011.
In the whole of 2016, holdings fell $289bn. China accounted for $136bn of that. Japan is now the largest holder of US Treasuries. That is significant and maybe the new ‘great rotation’, as opposed to the traditional notion of transitioning from bonds to stocks.
But is there a relationship between China’s forex reserves and US yields? At the beginning of 2003, China’s reserves were around $400bn, while the US 10yr sat around 4%. Over the last decade or so, China has been accumulating reserves at a tremendous rate, which peaked in early 2014.
From that point onwards, there has been a negative correlation of around -0.3 between yields and forex reserves. Although the figure is not deeply negative i.e. -0.7/-0.8, it does highlight some key ideas. Apart from the Trumpflation trade, yields rose for some key reasons, namely China offloading its US debt holdings.
As rates rose, forex reserves were low because the PBoC was trying to defend the yuan against an ever-appreciating dollar. Between 2000-2011, the correlation was around -0.8 because reserves were being acquired and yields were heading south, in part due to the global savings glut from the surplus countries like China and Japan, which in turn pushed down on US interest rates.
Numbers aside, what does this actually mean for the economy and thus future policy?
The US needs to improve its infrastructure and will likely be financed by issuing a century bond yielding approximately 3.5-4%. Historically, it was a given that China would assume some of the debt, but would they want to help out in a Trump era? If they do not because higher growth implies higher interest rates, who will pick up the bill?
If relations between China and America decline further, which one could see happening, given diplomacy is not exactly Trump’s strong point, the US will need to rely on other countries/ institutions to bid.
Chinese firms have borrowed a lot in dollars and if they continue on this path, when rates rise, their costs will rise too. Furthermore, as China is forced to run a strong currency policy, this will slow the dollar ascension marginally because the Chinese will be forced to sell some of their forex reserves. This scenario gives the Fed the green light to hike further. Not good for Chinese corporates. So oddly, selling reserves to maintain the peg will create domestic issues from higher borrowing costs.
The alternative is to abandon the trading band all together and become freely floating, although this is unlikely to happen in the foreseeable future.