Why China May Add Volatility To Bonds In The Weeks Ahead
Last Thursday, before the blackout occurred, there was a news headline that
appeared on Bloomberg which caught my attention. The news service reported early
during the day that Goldman Sachs had released a letter to its clients
stating that there was a strong likelihood that China may allow its currency to
strengthen before the G-7 summit takes place on September 20th–amid mounting
pressure from the world’s major economies. If this where to happen, it would
likely be a token gesture on the part of the Chinese and therefore have minimal
long-term effects on the financial markets. However, intraday volatility in the
US bond markets may increase along with the increased rhetoric and speculation
leading up to the summit next month. As such, market participants should be
aware of what’s going on here. Â
Why does this development affect the US markets?
China’s central bank has in recent years become one of the biggest purchasers
of US Treasuries. The reason is that China’s economy is highly dependent on exports,
which are reaching record levels against the US, for its livelihood. In an effort to keep
its goods competitively priced, the central bank keeps its currency, the yuan,
fixed at 8.3 to 1 US dollar. When foreign goods and services are sold in
the US the revenues from these transactions need to be repatriated back to the
exporting country, which means that US dollars are exchanged (sold) for foreign
currency (bought). This then pushes the value of the US dollar lower relative to
the currency of countries that have trade surpluses with the US, as is the case
with China. However, China prevents its currency from becoming subject to the
laws of supply and demand because it intervenes in the foreign exchange markets
to keep the yuan fixed.
Most of the US dollars that are purchased by China’s central bank go towards
purchasing US Treasuries. In fact, China now owns $121.7 billion worth of US
government debt. As can be seen in the graph below, foreign central bank
ownership of US Treasuries has jumped over the past two years, after remaining
relatively steady during the 90’s–most of this increase can be attributed to
China’s growing trade surplus with the US.
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height=”292″ />
As I mentioned earlier, the most likely scenario is that China’s central
bank, in a token gesture, will widen the band around the currency peg, which
would have a limited long-term impact on the world’s financial markets, but
possibly create some decent intraday volatility–similar to that experienced
last Thursday after the report was released–for the US bond markets.Â