A China Conspiracy Theory: “What If Beijing Is Behind The Entire Move?” SocGen Asks

As noted earlier, the return of the “Trump Trade”, however brief, on the back of tax reform euphoria and Hawkish Yellen has dominated market sentiment, resulting in the latest bond market “crash”, sending yields to a nearly three month high of 2.35% earlier this morning, and as Bill Blain showed in a chart, it took just three weeks to reverse the fall we saw in July and August, up 30bps in days, while Bunds are up 20bp and even JGBs are up 5bp (far greater rises in relative terms).

Meamwhile, the FX market has continued to shadow every tick in the bond market. The Dollar index reached its low point on 8 September, as EUR/USD spiked to just below 1.21. Since then the EUR/USD has fallen to levels not seen since mid-August, but that’s not a huge correction given that relative (real) yields are back to where they were in mid-May (when EUR/USD was under 1.11).

Putting the rate and FX moves in context, SocGen’s FX analyst Kit Juckes writes that the moves over the last three weeks are big, but can easily be dismissed as a reaction to the excessive gloom of late August (when the fed wasn’t going to hike again in 2017, Donald Trump’s war of words with Kim Jong-Un was beginning to make daily headlines, hurricane season was just beginning to affect economic sentiment and hopes of any fiscal easing had died). “On that take, the rise in US yields will slow, USD/JPY can rise further, and we’ll soon be at levels where EMFX carry trades and long EUR/USD are attractive.”

But most interesting is Juckes’ proposal that according to an “alternative theory” this month’s moves originate not in Washington, but Beijing… He explains below:

Plotting 10year Notes against DXY provides the conventional view and the basis for what follows: The dollar turned higher as yields troughed, and once we’ve pried in a tax plan, a December rate hike, a couple more Fed hikes for 2018 and some political uncertainty in Europe, we can get back to our central scenario. But 8 September also saw the low in USD/CNH and USD/CNY. They have bounced because over the weekend of September 9/10, the Chinese authorities decided to scrap two measures aimed at supporting the Yuan when it was falling too fast (reserve requirements for institutions settling forward Yuan positions and foreign banks’ reserves against offshore Yuan deposits.

The Yuan has appreciated by 4% against the US dollar this year, despite the fall in September. However, that tells only a very small part of the story. In trade weighted terms, the Yuan is cheaper than it was at the end of 2016, and considerably weaker that it was at its peak in 2015. The Chinese policy of letting the currency weaken is intact. 

One school of thought is that the Chinese have played their cards exceptionally well this year in the FX market. At the beginning of the year, as President Trump made accusations of FX manipulation and unfair trade practises, it was clear that a further rise in the USD/CNY rate would be inflammatory. But the stronger euro, and the weaker dollar generally, came to Beijing’s rescue. That allowed USD/CNY to fall without the value of the Yuan overall going up. At the same time, the weaker dollar stopped the fall in Chinese currency reserves. Official data show these recovering slightly. Data on their holdings of treasuries show a relatively bigger bounce. One interpretation is that China has been accumulating Treasuries to stop the Yuan appreciating too fast, buying Treasuries and driving yields lower than they would otherwise have been. Was that 2.03% 10year Note a function of expectations about the Fed, inflation and fiscal policy, or the result of Chinese buying in summer markets?

Lower US yields helped the dollar fall broadly, and so helped all the other currencies in China’s trade-weighted basket. A Machiavellian read would suggest that the Chinese were quietly buying EUR/USD to rebalance their reserves, preventing any correction and playing their part of the divergence of EUR/USD from relative yields, watching EUR/CNY reach levels not seen since 2014.

To summarize, if Chinese reserve accumulation drove yields and the dollar down, supporting higher-yielding currencies in general, then the previously discussed dramatic reversal by the PBOC on September 8 marked the turning point. Or as Juckes puts it, “policy was changed, signalling the end of Yuan appreciation, the end of the rally for Treasuries, high-yield currencies and the euro. When USD/CNY stops rising, buy EMFX and EUR/USD again?”