Don’t look now, but suddenly, the dynamic we began warning about last November [15] is the talk of the financial universe and it only took one earth-shattering currency devaluation and the liquidation of a few hundred billion in US paper in the space of just two weeks to wake everyone up.
We have, as Deutsche Bank put it on Tuesday, reached the end [16] of the “Great Accumulation” as slumping Chinese growth, plunging crude, and an imminent Fed hike have put enormous pressure on emerging economies’ accumulated stash of FX reserves and that means that buyers of USD assets are becoming sellers at the expense of global liquidity and the perpetual bid for some core paper.
Of course this didn’t just happen in the last two weeks as (almost) everyone would have you believe. This began quite some time ago and the death of the petrodollar was in many ways the starting pistol for what Deutsche Bank has correctly identified as an epochal shift.
Well, for anyone who’s lost sleep wondering what Goldman thinks, you can relax, because the “smartest” guys in the room - whose former employee at the ECB will be watched closely this week for any possible response to the China turmoil - is out with their take, excerpts from which you can find below (note the multiple nods to the fact that this began with the dying petrodollar).
* * *
From Goldman
Falling FX Reserves and Rising Bond Yields: Some Macro Considerations
There is increasing focus among investors on the decline in FX reserves across Emerging Markets, and in China in particular, and the negative impact this could have on government bonds in general, and more specifically on US Treasuries.
We view such dynamics as part of an ongoing structural shift in international trade and capital flows which will interact with the increase in bond yields in the advanced economies embedded in our baseline forecasts. On balance, the decline in foreign official sector reserves represents a headwind for government bonds over the medium term.
When assessing the near-term impact on fixed income resulting from these forces, however, we would advise against following a narrow flow-of-funds approach, as the correlation between changes in official sector flows (which are available only with a lag) and changes in yields is unstable, and shifts in macro expectations ultimately tend to win the day.
In big picture terms, the rise in foreign FX reserves held by non-G-7 countries that started around 2003-04 (at around US$1trn) appears to have ended for good – particularly if our ‘new oil order’ template holds, keeping crude oil prices around current levels (at least for now, official FX reserves in the advanced economies are not being diversified into CNY to a materially relevant degree). Here are some key facts:
- Official sector FX reserves held by a broad set of countries outside the G-7 peaked about a year ago. Data compiled by the IMF suggests that, in Dollar terms and excluding gold, FX reserves fell from US$7.7trn in June 2014 to US$7.1trn in June 2015 – the last data point available. The reduction has been led by China (which accounts for just over half of the total amount of FX reserves quoted here and has seen a fall of US$300bn over this period) followed by the group of oil-exporters such as Russia (-US$120bn), Saudi Arabia (-US$67bn) and Malaysia (-US$26bn).
- The decline in FX reserves reflects primarily lower accumulation of hard currency from the current account channel, related to the fall in commodity prices and shifts in relative competitiveness across regions. The depletion of FX reserves stemming from the capital account side in countries that have resisted exchange rate depreciation is a more recent phenomenon. China is among this latter set of countries, and the scale of the outflows has attracted much attention. In the first 6 months of the year, China has lost on average US$10bn reserves per month, in spite of an average monthly US$25bn addition in reserves from the current account side. In July-August, concomittant with the unexpected shift in the FX management policy, the decline in FX reserves could be well north of US$100bn, although there is considerable uncertainty around these numbers.
- Although there has been a large currency diversification of FX reserve pools, especially since the Financial Crisis, the lion's share of official reserve assets is held in US Dollars. In the case of China, we estimate that around two-thirds of the PBoC’s reported US$3.5trn reserves are held in Dollar-denominated cash and fixed income (mostly Treasury and Agency securities, with an average duration of around 5-6 years). This split between Dollar holdings and other currencies is representative for other central banks across Asia and the Middle East, although duration is in the aggregate lower. Central bank reserves held in EUR are largely invested in ‘core markets’ (e.g., Germany and France). So it is broadly correct to assume that a decline in FX reserves will affect proportionally more Dollar-denominated fixed income.
- To the extent that the FX reserve decline is the counterpart to capital outflows, a relevant question in this context is where these private sector funds are heading. If the answer is back into Dollar fixed income securities, the impact on the pricing of the latter would be at least partly neutralized. If it is hard to say what assets central banks are selling to accommodate the demand for hard currency, it is even harder to tell where the Dollars now held in private hands are being invested. It seems reasonable to assume that, in the short term, central banks would first sell cash-proxies, and new private sector holders of Dollars park them in fixed income instruments. Over time, however, the risk preference of the private sector is likely to be higher than that of the central banks, and the privately held Dollars would find their way into riskier assets (real estate and securities, held directly or through intermediaries), resulting in a gradual transformation of EM claims against advanced economies (e.g., the PBoC holds fewer Treasuries, the Chinese private sector more foreign risky assets).
Bonds’ macro underpinnings may shift further: The fall in FX reserves in China and in commodity exporting economies has occurred together with a shift in expectations on global growth and commodity prices. Since the start of this year, our colleagues have downgraded 2017-2018 US real growth by a cumulative 75bp to just over 2%, and the corresponding Chinese numbers have also come down by 50bp to just below 6%. At the same time, primarily reflecting supply-side considerations, our medium-term commodity projections have fallen over the past quarters. These shifts are not inconsequential for the fixed income market outlook. We have argued that, among asset classes, government bonds are already discounting a very depressed trajectory for real forward rates, and offer little risk premium. This, rather than lower central bank buying, is why we forecast poor returns. But a bigger slowdown in China, or an even larger fall in oil prices – of which larger capital outflows and FX reserve depletion could be a symptom – would likely be associated with deeper revisions in prospective nominal growth in the developed world. This would lower our sights for bond yields, not lift them.
