A few days ago, I mused on the XSO thread that Quantitative Tightening (QT) would be the buzz phrase of 2016.
http://hotcopper.com.au/threads/the...3326/page-10473?post_id=15972852#.Vfji3RGqqko
For those not familiar with the topic, a bit of background:
As we all know, China’s growth over last 30 years has been primarily export driven. Their fixed currency peg allowed them to keep the yuan artificially low to maintain export competitive advantage resulting in an enormous trade surplus.
http://www.tradingeconomics.com/china/balance-of-trade
…… which in turn resulted into enormous FX reserves.
http://www.tradingeconomics.com/china/foreign-exchange-reserves
Most of these surplus foreign currency units are sold in exchange for easily stored assets such as
t-bills, bonds and equities…and of course some less easily stored assets such as gold (for diversification only …not because they are trying to float a gold backed yuan as the foil hat brigade will have you believe). Circa 40% all China’s $3.5 Trillion reserves are in US Treasuries.
Over the last 10 years, to support their transition to a more consumption based economy (and likely due to pressure from trading partners though they would never admit it), allowed their currency to slowly appreciate via a new “managed floating system”(as oxymoronic as that sounds) that allowed small variations based on market forces, as opposed to a 100% fixed peg. This simply meant market forces allowed the currency to slowly appreciate given it had been artificially low. Of course the PBOC still retained the ability to manipulate the rate if the need arose, as it did in 2008 when it fixed the rate again.
Since 2013 as it became apparent the Chinese economy was slowing, capital flight started to force the currency down, although due to the tight restrictions, it was not depreciating fast enough to reinvigorate the economy. This prompted the PBOC to intervene. They tweaked the fix in August this year to allow market forces to have a greater impact, which resulted in a sharp drop.
http://www.xe.com/currencycharts/?from=CNY&to=USD&view=10Y
This downward pressure on the yuan from both capital outflows over the last 2 years and more recently, PBOC intervention, needed to be balanced out by selling FX Reserves to maintain control over the “managed floating system”. Given the huge amount of US treasuries held in China FX reserves, this selling is significant and could have a big impact on the US debt market, interest rates etc. This sale of treasuries back to the market has been described at QT. Mass selling of treasuries (QT) has to be the opposite of mass buying (QE) right? At least that’s what all the articles I’ve read have proposed.
Now this is where my thinking has recently changed…or more specifically I’m challenging my thinking, I’m still not sure if I’m right.
Conventional wisdom suggests that as the PBOC sell treasuries they exchanged for USD’s in their FX reserves, pulling them out of circulation, forcing USD up and forcing interest rates up (due to increase supply of treasuries). Ie: monetary tightening. In this case the risk is that it will halt the US recovery in it’s tracks, and at the very least rates on hold indefinitely, if not eventually QE4.
The problem with this theory is the Chinese don’t want more USD’s in their reserves…that would defeat the purpose.
It is not exchanging Treasuries for USD’s that supports the yuan, it is sale of dollars in exchange for yuan. So I believe they will sell treasuries in exchange for USD’s then sell the same USD’s for yuan. The net effect is that dollar liquidity remains neutral, but supply of Treasuries still increases. This would still put pressure on the Fed to hold rates, but it could have other serious implications for investors. Potential for a blow off top in markets, and potential for bond bubble to burst to name just 2. Last night big money was selling fixed income instruments and deploying proceeds to stocks. Is this and early heads up? Interest rates rose across all maturities, but in particular 2 year note. China’s holds predominately short term treasuries in their reserves….
Of course the key to unravelling all this is fully understanding China’s intentions for devaluing their currency and/or why they are selling FX reserves. If my assumptions above (ie supporting their currency from collapsing due to capital outflows and yuan depreciation) proves to be false, then it will change the whole picture. Their intentions in both these cases, would give us a big clue as to where global markets head in the coming years.
Would love to pick the brains of the learned folk here to see if any other theories or if you can poke holes in mine.
The reason for my question on USD chart was to see if there were any hints as to which way this will go.
@timber1956, with your background, if you have time I’d really appreciate your thoughts on this topic.
Cheers
(20min delay)
