Over the weekend, we noted something unexpected: the yield differential between Chinese and US 10Y Yields had collapsed in the past month, dropping to under 30bps, the lowest level in years, as the market appeared to telegraph that China would not only be unlikely to spur inflation, but more concerningly, succumb to deflation.
Chinese 10Y yielding just 29bps more than US 10Y Treasury: market saying China deflation coming pic.twitter.com/SkEXuNd8gz— zerohedge (@zerohedge) November 17, 2018
However, while there is still time before Chinese 10Y paper yields less than its US equivalent, a look at closer maturities reveals that for the first time in decades, one-year Treasuries yield more than short-term Chinese debt, which BMO Capital Markets said would spell further trouble for China’s currency.
The recent sharp drop in 12-month Treasury bills, the result of the Fed's push to hike rates despite concerns about the slowing US economy, has sent 1 Year yields to 2.66%, rising above the 2.56% yield on matched-maturity Chinese securities for the first time since at least 2008. Putting this dramatic move in context, at the start of 2018, the Chinese 1 Year government paper yielded about 200bps more than the T-bills.
"For the first time in decades, a 12-month Treasury bill has a higher yield than one-year Chinese debt," BMO rates strategist Jon Hill wrote in a Monday note, echoing what we said a few weeks ago, namely that the collapse in the rate differential "should put further depreciation pressure on the renminbi which would serve as a disinflationary force domestically, and help to offset the taxes on imports."
Meanwhile, the divergence of monetary policy between the tightening Federal and the easing PBOC means the gap is likely to keep growing, leaving the yuan increasingly vulnerable.
In addition to indicating that the market is increasingly concerned about the stability of China's economy, the slumping yields and resulting yuan devaluation - which will almost certainly push the yuan below the critical "redline" level of 7.00 against the dollar - it will also further infuriate the Trump administration.
As the trade war between the US and China escalates, the offshore yuan has weakened 6% against the dollar this year, making it one of the worst-performing Asian currencies and raising speculation that China has been deliberately weakening its currency amid trade tensions with the US; it also prompted repeated accusations by Trump that Beijing is purposefully devaluing its currency, resulting in threats of even harsher sanctions should China fail to address US concerns, leading to even more aggressive retaliation in the ongoing currency and trade war.
BMO sees those woes deepening especially after Vice President Mike Pence renewed U.S. attacks on China at the Asia-Pacific Economic Cooperation summit, which ended on Sunday in dramatic fashion without a joint statement for the first time since 1993, as the full extent of disagreement between Washington and Beijing was made public.