We pointed out previously that the one certain mid- to long-term impact of China's revaluation decision, aside from stimulating the US manufacturing export economy (don't laugh), will be to trim Chinese interest for bonds. This is due to a direct effect of fewer Chinese dollars being recycled into USTs now that less USD reserves will be accumulated, but also due to an indirect effect of stimulating demand for risky assets, pushing USTs off the plate of investors. For a much more in depth perspective, we provide the views of MS Rates strategists Jim Caron and Igor Cashyn.
China’s RMB Revaluation – Bearish for US Treasuries over the Long Term
Jim Caron, Igor Cashyn
From a US rates perspective, China's decision to exit from the renminbi (RMB) peg to the USD and allow its currency to strengthen is, at the margin, bearish for UST bonds over the long term. It simply means that China will accumulate USD reserves at a slower pace, although we note that the pass-through between FX and reserve growth is not always linear. With marginally less dollars to recycle into USTs, we anticipate that the size of the direct impact of allowing the RMB to strengthen – say a 5% revaluation – will likely be slight – on the order of ~$12 billion less coupon USTs purchased per year. Still, the importance of this is clear, as China is the largest creditor to the US Treasury, and this lower purchasing flow will have to be priced in at some point.
The much more immediate bearish impact on Treasuries may stem from the positive indirect impact this revaluation has on risky assets, as the revaluation should be supportive for US growth dynamics and many emerging markets. Our China economist, Qing Wang, broadly goes into the positive risk sentiment borne out of China’s decision to revalue its currency. They are as follows:
i. Reduction in risk premiums stemming from fear of a Sino-US trade war;
ii. It reduces the probability of an aggressive policy tightening or heavy-handed credit controls; and
iii. It increases the probability for further revaluation over time.
We believe that the revaluation should minimize any disruptive influence on the AXJ region and the global economy. We still see emerging markets as the engine of world growth, at 7.3%, with China growth alone running at 11% in 2010. The revaluation effectively provides a tailwind for global imbalances to start a process of rebalancing in which the US will be a prime beneficiary. It is for these reasons that we believe that the revaluation is bearish for USTs but underscores that these bearish forces would take a long time to play out. Further, the size of the revaluation is not yet known, and as of June 20, this foreign exchange rate is unchanged at 6.8275.
China’s allocation of foreign reserves. To understand what direct impact China’s decision to revalue its currency will have on the US rates market (i.e., how much less US assets China will buy), we first have to examine which assets are likely to be most impacted. That is, where does China invest its dollar reserves? In Exhibit 1, we illustrate China’s holdings of various US securities from the Treasury’s annual survey of US securities held by foreign entities, with the latest report published for June 30, 2009. We then use the Treasury’s monthly TIC flows to bring this data up to speed through April 2010, although we caution our readers that the monthly TIC flows are likely to understate the true growth in Chinese purchases as flows conducted via money-center banks in other countries (e.g., the UK), may not be attributed to China
right away. Instead, they are corrected only in the annual survey. Thus, the $101 billion inflow into Treasuries between June 2009 and April 2010 is likely underestimated.
We find that pre-crisis, China – like so many other sovereign at the time – favored US spread products over risk-free Treasuries. However, this all started to change for the year ending in June 2009 – the latest available annual survey, when China ramped up its purchases of coupon Treasuries and became an outright seller of both Agency debt/MBS and Corporates (see Exhibit 1). And while China has slowed its selling pace of Agency debt/MBS as of April 2010, it has yet to fully return into this space. Thus, of the market’s in which China has been historically active, it is the US Treasury market that will be most impacted by any shift in China’s dollar reserve growth.
Sizing the direct impact. Exhibit 2 presents historical changes in the RMB/USD exchange rate, the growth in China’s total foreign exchange reserves (i.e., not just US$ reserves), and China’s purchases of coupon Treasury debt. We note that China’s total foreign reserves actually increased the most for the year ending June 2008, or at the precise time one would have expected China to decrease given the 10% strengthening of its currency. One rationalization is that a stronger currency was needed to offset an even larger growth in China’s foreign reserves, but more importantly, this goes to show that the pass-through effect on China’s reserve growth is far from linear. Therefore, it may be hard to trade the impact of the latest revaluation move via a view on Treasury yields.
However, if we were to assume that, for example, a 5% RMB appreciation over a 1-year period led to a 5% drop in its foreign reserves growth and a corresponding drop of 5% in its coupon Treasury purchases, this would lead to only a $12 billion drop (assuming that the Jun09 annual inflow of $235 billion stays constant). Compared to annual net issuance pace of coupon Treasuries at $1.367 trillion and $1.110 trillion in F2010 and F2011 (see Exhibit 3), a $12 billion drop in purchases will have a marginal impact at best. But again, as we stated above, we do not expect a revaluation of the RMB to have a linear correspondence to UST purchases or yields.
Impact on the UST yield curve. This will also be difficult to discern. On one hand, Treasury auction data indicate that aggregate foreign investor purchases – a good proxy for China’s own flows – have targeted the 3y UST sector with the 5y sector next in line. So, one could argue that a revaluation in the RMB and subsequent slowing of UST purchases might impact this sector most and the yield curve might have a bias to flatten from the 3y-5y sector on out. But on the other hand, to the extent that a currency revaluation is supportive of US growth dynamics and other risky assets, then one could argue that the more immediate impact would be a steepening of the UST yield curve. The important thing to remember is that China’s currency policy is only one of many factors that might influence the shape of the yield curve.