First, we present the chart, followed by some brief color and analysis.
[7]
Over the past two weeks, the world has begun to understand that, as Citi recently put it, EM FX reserve drawdowns do not "happen in a vacuum." That is, when emerging economies are forced to liquidate billions in USD assets to offset capital outflows, defend their currencies, and/or plug yawning budget holes, it puts pressure on those assets and works at cross purposes with the expansion of the Fed’s balance sheet.
This dynamic is unfolding rapidly at present across EM. It began last November with the quiet death of the petrodollar [8] and has now culminated with the liquidation of more than $100 billion [9] in USTs by China during the last two weeks of August. The story, reduced to its simplest possible form is as follows. Saudi Arabia’s move to keep crude prices depressed in an effort to bankrupt the US shale space and tighten the screws on Moscow exacerbated a commodities downturn, sparking capital outflows from EM assets and pressuring EM currencies. In this environment, the yuan’s REER appreciated to the tune of 15% thanks to the RMB dollar peg, a situation which ultimately proved to be untenable for China amid decelerating economic growth. Apparently failing to realize that, as SocGen notes, the only way to have a stable currency is to either exercise absolute control or no control at all, China chose a half-measure and now, frequent open FX interventions are draining the country’s UST holdings (for more, see "Why It Really All Comes Down To The Death Of The Petrodollar [10]").
In the end, what started last November with the beginning of the end for the petrodollar, has created a situation where USD reserve assets are being liquidated across the emerging world with the two focal points being China and Saudi Arabia which have, respectively, the first and third largest stores of FX reserves on the planet. Needless to say, if both the Saudis and the Chinese continue to drawdown these reserves, the Fed would be forced to implement a massive round of asset purchases to offset the pressure on USTs and in turn, on the US economy.
Given the above, it would likely be no exaggeration to say that perhaps the most important chart in all of global finance is the one shown above: the yield on the 10Y Treasury bond versus the combined FX holdings of China and Saudi Arabia.
