donderdag 11 januari 2018

Chinese whispers sink US bonds


Nick Hubble

Dear Reader

Well, yesterday’s Capital & Conflict proved timely. A bear market in bonds is the top story right across the financial media this morning. The Financial Times, Bloomberg and others all feature stories about wobbly bond markets and jittery yields.

Yesterday we looked into the consequences of a bear market in bonds. In short, the biggest tailwind of investing in the last 50 years would become a headwind.

For governments and companies, rising interest rates would mean bigger interest bills. For investment funds, the falling capital values of bonds would upset the entire premise of owning them. For mortgage borrowers, repayments would go up.

So all this is rather important. The question is, will it really happen? And what do you need to look for to get an early warning?

At the top of the news cycle this morning is China. China owns more than a trillion US dollars in American government debt, known as Treasuries. That’s the official figure, anyway. Unknown holders using funds in Belgium own a vast chunk too. Many are probably middlemen for the Chinese.

A few years ago, a video about the implications of China’s holdings of US Treasuries went viral. The script was very clever. It features a Chinese university lecturer in 2030. He explains to his class why empires end. Profligacy, taxing and borrowing. From Ancient Rome to the British Empire, financial misbehaviour leads to doom.

And so it was for the American empire too, explains the professor with a smirk. “Of course, we owned most of their debt. So now they work for us.” Cue the evil laughter.

The updated version of all this is that China could sell all its American debt. That’d send financial markets into a tailspin and expose the US’ fiscal mess. Interest rates would surge. They call it the nuclear option.

But it wouldn’t necessarily take selling debt to cause trouble. Given China soaks up a vast amount of US debt each year, just stopping its purchases could signal trouble for the US budget.

In fact, just the tentative suggestion that the Chinese definitely might have a firm possibility of maybe ending their purchases was enough to rile US Treasury markets yesterday:

Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.
The US dollar took a hit too. In fact, the S&P 500 stock index posted its first loss for the year. But not long after, the ten-year Treasuries recovered after a debt auction went off without a hitch. False alarm.

But the news report from Bloomberg doesn’t confirm the Chinese will actually follow the recommended policy of ending purchases. They couldn’t get confirmation. This line in the Bloomberg story made me laugh out loud: “China’s State Administration of Foreign Exchange didn’t immediately reply to a fax seeking comment on the matter.” Yes, a fax.

Plenty of people aren’t that worried about China’s role in debt markets. The Chinese would only be shooting themselves in the foot if they caused trouble. By holding so many Treasuries, dumping them would be self-sabotage. They can’t sell enough of them fast enough to exit cleanly.

That’s a silly argument because buying the Treasuries costs China nothing in the first place. It printed the yuan that manipulated the exchange rate to keep the trade surplus going.

But dumping Treasuries would reverse this currency manipulation policy. The yuan would surge, messing with China’s export jobs boom. That’s the real reason China must be careful.

Japan went through all this in the 90s, by the way. It wasn’t able to sell out of its vast Treasury holdings either.

But are China’s holding’s really that vast? Bloomberg’s Ye Xie pointed out that the world should be able to absorb China dumping its Treasuries anyway:

China added $131b in Treasury holdings in the first 10 months of last year, or $13b a month. How much U.S. government securities traded among primary dealers in every single day last year? More than $500b. While China’s actual purchases may be bigger than the official data because it may have covered its trail in accounts in places such as Belgium, the truth remains that the ocean is just too big for one whale to make a splash, even as large as China is.
In other words, China is just one of many players.

But the other sources of demand for Treasuries are looking shaky too, just when deficits are about to surge. Donald Trump’s tax cut needs to be financed, central banks are unwinding quantitative easing, pension funds are depleting and yields are at absurd lows. Inflation is on the move too. In other words, China isn’t the only warning sign.

The issue here is one I explained yesterday. The moment bond markets lose their upward momentum, the premise of holding them completely changes. If you’re expecting capital losses over time, instead of gains, then it only makes sense to hold bonds to maturity. And not many people do, as the vast trading figures Ye mention above shows. The demand for Treasuries could drop out on a change in momentum.

The indicator to watch for this is volatility in yields. Alongside bond yields themselves, volatility in the Treasury market is at extraordinary lows. Lows last seen in the 1970s… shortly before bonds went into an epic bear market.