This past July, we lamented that as a result of the now implemented money market reform which sent Libor soaring, Wall Street had lost one of its most dependable, forward-looking crisis indicators: the TED-Spread (the difference between LIBOR and 3 month TSYs), something which Bloomberg also figured out last week.
Specifically, we said that "now the regulatory intervention is set to pressure what have traditionally been reliable metrics indicative of funding stress and systemic risk, among them swap spreads, the TED-Spread and the FRA-OIS spread, the market is about to lose the last metric indicative of underlying tensions. After all, with central bank intervention having broken all conventional signalling pathways, including equities, corporate bonds, Treasuries, and VIX, there will no longer be any reliable sources hinting at fundamental risk in the market, certainly for the short-term and perhaps over an indefinite amount of time."
However, one place where the TED spread - ironically - is still a valid indicator of liquidity concerns, is oddly enough China. And it is in China where traders in the local interest-rate swap market are bracing for a cash shortage as a result of the blowout in the premium for the 1-year swap rate over the 1-year sovereign bond yield to 52 basis points, the widest since July 2015.
As Bloomberg reminds us, this is China's version of the familiar TED spread, which in the US is (or rather was) a gauge of stress that compares funding costs for banks and the government.
“This is a signal in the market that swap traders are readying for tighter liquidity as the government tries to prevent a property bubble,” said Iris Pang, senior economist for Greater China at Natixis Asia Ltd. in Hong Kong. “Further tightness may be very limited because the PBOC doesn’t want to put financial stress on the market.
The good news: it is still well below the 140 basis points reached during the trust finance crackdown of early 2014. The bad news is that as reported last week, China has just launched a new crackdown, this time on on the infamous Wealth-Managemnt Products, shadow banking conduits which amount to just under $1.9 trillion in products, the immediate result of which has been the recent 10% surge in bitcoin. Which means that should absent another liquidity injections elsewhere, the drought is set to get far worse.
The recent, sharp move in the swap spread is the result of market concerns that the government is seeking to crackdown on the local housing bubble:
The fixed cost to receive the seven-day repurchase rate for a year climbed to an 18-month high on concern the People’s Bank of China will tighten its purse strings after property prices surged 40 percent in Shanghai last month from a year earlier. The one-year swap rate reached 2.73 percent on Friday in Shanghai, matching the highest level since April 2015, while the seven-day repo rate reached a one-month high on Thursday. The one-year sovereign yield was at 2.19 percent, heading for a third annual decline.
Making matters worse, China Securities Journal reported on its front page that finance companies need to prepare for "tight days" as monetary policy shifts to focus on deleveraging.
The "good" news from this upcoming liquidity shortage, is that China's government bond yields, already near all time lows, are set to drop even further, as bond investors - who assume the market's reaction to a Chinese growth slowdown is similar to that in the US - are preparing to benefit from the slower economic growth that may result. "Any decline in real estate activity is likely to dent growth in the world’s second-largest economy, providing a tailwind for government bonds", according to ING and DBS.
And while it is all connected, the liquidity shortage, the drop in yields, and the rising swap spreads, the cash squeeze also reflects the flight from a weakening yuan. While China's SAFE reported that 44.7 billion in yuan payments left the nation last month, up from August’s outflow of $27.7 billion, Goldman's calculation was nearly double that, or some $78 billion in September outflows. As a result of the return of China's banking sector bogeyman, which as we reported last week just hit a staggering 200 trillion yuan...
... the Chinese currency continued to slide this past week, bringing its drop against the dollar to 4.2% YTD, the most among 11 Asian currencies tracked by Bloomberg.
How should one trade this reacceleration in Chinese capital outflows, Yuan devaluation and overall economic deterioration? One way, as Kyle Bass has done, is to short the Yuan outright, and in size. Another, as we did last September, and as Corriente's MarK Hart discussed in February, is simply to go long bitcoin - a trade that has returned over 200% in just over a year.
Of course, one doesn't have to trade it at all: sitting back and watching events unfold may be just as satisfactory.