Critical Observer

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Shortly after the PBoC’s move to devalue the yuan, we noted with some alarm that it looked as though China may have drawn down its reserves by more than $100 billion in the space of just two weeks. That, we went on the point out, would represent a stunning increase over the previous pace of the country’s reserve draw down, which we’ve began documenting months ahead of the devaluation (see here, for instance). We went on to estimate, based on the estimated size of the RMB carry trade unwind, how large the FX reserve liquidation might need to be to offset capital outflows and finally, late last week, we suggested that China’s official FX reserve data was set to become the new risk-on/off trigger for nervous, erratic markets. In short, the pace at which Beijing is burning through its USD assets in defense of the yuan has serious implications not only for investors’ collective perception of market stability, but for yields on core paper, for global liquidity, and for US monetary policy.<br />
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On Monday we got the official data from China and sure enough, we find out that the PBoC liquidated around $94 billion in reserves during the month of August and as Goldman argues (see below), the “real” figure might have been closer to $115 billion. Whatever the case, it’s a staggering burn rate and needless to say, were the PBoC to continue to liquidate its assets at this pace, it would necessitate a raft of RRR cuts and hundreds of billions in short-term liquidity ops to ensure that money market don’t seize up in the face of the liquidity drain.<br />
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Here’s some commentary from across sellside desks on the official numbers:<br />
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From RBC’s Sue Trinh:<br />
China FX reserves suggest about $140b used to defend yuan in April once valuation is accounted for<br />
Believes PBOC has been intervening to maintain the yuan’s stability since the devaluation, but this kind of intervention can’t continue indefinitely<br />
It’s unsustainable in the long run; yuan is overvalued by around 15% by RBC’s latest estimate; still targeting USD/CNY at 6.56 by year-end and 6.95 by the end of 2016<br />
From Commerzbank’s Zhou Hao:<br />
Decline in foreign reserves clearly suggests China’s central bank intervened intensively in the FX market to stabilize CNY exchange rate<br />
“One-off devaluation” in mid-Aug. triggered market expectations of further CNY deprecation, which has not only endangered the financial stability, but also posts a downside risk to the economy due to capital outflows<br />
It’s costly because frequent intervention will burn foreign reserves rapidly and tighten the onshore market liquidity;that said, further tightening of regulations is expected near term<br />
Expects spread between CNY and CNH is likely to persist as PBOC has become an active player in onshore market<br />
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From Goldman:<br />
The People’s Bank of China (PBOC) reported that its foreign exchange reserves dropped by US$94bn in August, to US$3.557tn at the end of the month. However, it is not straightforward to derive the actual scale of FX reserves sales from the headline FX reserves data, given uncertain valuation effects and possible balance sheet management by the PBOC.<br />
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It is possible to get an approximate sense about valuation effects stemming from currency movement: e.g., assuming the currency composition of the PBOC’s FX reserves broadly follows that of the average country’s (using the IMF COFER weights, which suggest roughly 70% in USD for EM countries),the currency valuation effect would probably be positive to the tune of roughly US$20bn (i.e., if we only look at the change in headline FX reserves as a gauge of sales of FX reserves, sales of FX reserves might have been underestimated by around US$20bn, given the currency valuation effect).However, besides currency movements, there could also be significant valuation effects from changes to the market prices of the PBOC’s investment portfolios, and the direction and size of those effects is hard to measure given the uncertainty of the asset composition. Moreover, there could also be possible short-term transactions and agreements between the PBOC and banks that may complicate the interpretation of the change in FX reserves as an underlying measure of RMB demand.<br />
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Of course the huge draw down was widely anticipated and indeed, we’ve explored and detailed virtually every angle of this story in the lead up to the data. The key takeaway here is that we now have official confirmation that August saw $94 billion in reverse QE (and more likely $115 billion) or, quantitative tightening as Deutsche Bank puts it.<br />
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We can, as we explained on Saturday, argue about what the ultimate effect on safe haven assets will be, but what’s not up for debate is that conceptually speaking, China’s massive UST dumping is the opposite of Western central bank QE and as such should be expected to pressure yields. More specifically, Citi has suggested that for every $500 billion in EM FX reserve liquidation, there’s an attendant 108 bps or so of upward pressure on 10Y yields. Similarly, Deutsche Bank, citing the extant literature, flags 50-60bps of upward pressure on 5Y yields for every $100 billion in monthly EM FX reserve liquidations.<br />
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The takeaway, as we put it last week, is that if the Fed hikes this month, it will be tightening into a tightening.<br />
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But it’s not that simple. It’s also possible that, if China’s FX reserve draw downs do indeed end up serving as a trigger for risk-off behavior (i.e. a selloff in risk assets), the subsequent flight to safety could end up driving yields on long bonds lower, not higher. We discussed this in detailover the weekend.<br />
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Still, China isn’t the only country liquidating its USD assets.When you consider that global EM FX reserves amount to more than $7 trillion, it seems reasonable to ask whether the flight to safety that would invariably accompany a worldwide selloff in risk assets would be sufficient to replace the lost bid from massive reserve draw downs. Or, as we put it on Saturday, “the real question is what would everyone else do. If the other EMs join China in liquidating the combined $7.5 trillion in FX reserves (i.e., mostly US Trasurys but also those of Europe and Japan) shown below into an illiquid Treasury bond market where central banks already hold 30% or more of all 10 Year equivalents (the BOJ will own 60% by 2018), then it is debatable whether the mere outflow from stocks into bonds will offset the rate carnage.”<br />
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And that consideration, in turn, puts the Fed in a very, very difficult spot. A rate hike cycle will put further pressure on already beleaguered EM currencies which raises the possibility that the FX reserve liquidation will be larger than the eventual safe haven flows and besides, there’s bound to be a lag between the liquidation of USD assets and the flight to safety and given the potential for extraordinary bouts of volatility in UST, JGB, and German Bund markets, it’s anyone’s guess what happens in between.<br />
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Whatever the case, something will have to give here. That is, all of these dynamics (i.e. a Fed hike, China’s massive UST dumping, an EM meltdown precipitating FX reserve drawdowns, illiquid markets for the same assets everyone is dumping, hemorrhaging petrostate budgets, etc.) simply cannot coexist for long without something snapping because, as we put it last week, in this very unstable arrangement, the smallest policy error will reverberate exponentially, and those reverberations can lead to only one thing: the Fed’s admission of policy failure by adopting a tightening bias, and ultimately launching another phase of monetary easing, be it QE4 or perhaps even the long-overdue and much anticipated Friedmanesque “helicopter money” episode.

China Dumps $94b US Treasurys In One Month

Shortly after the PBoC’s move to devalue the yuan, we noted with some alarm that it looked as though China may have drawn down its reserv...

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<span style="line-height: 1.1;">On Tuesday evening, </span><a href="http://www.zerohedge.com/news/2015-08-26/what-would-happen-if-everyone-joins-china-dumping-treasurys" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; line-height: 1.1; outline: none; text-decoration: none;" target="_blank">we asked</a><span style="line-height: 1.1;"> </span><span style="line-height: 1.1;">what would happen if emerging markets joined China in dumping US Treasurys.</span></h5>
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For months we’ve documented the PBoC’s liquidation of its vast stack of US paper. Back in July for instance, we noted that China <a href="http://www.zerohedge.com/news/2015-07-17/china-dumps-record-143-billion-us-treasurys-three-months-belgium" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; outline: none; text-decoration: none;" target="_blank">had dumped</a> a record $143 billion in US Treasurys in three months via Belgium, <a href="http://www.zerohedge.com/news/2015-07-21/chinas-record-dumping-us-treasuries-leaves-goldman-speechless" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; outline: none; text-decoration: none;" target="_blank">leaving Goldman speechless</a> for once.</div>
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We followed all of this up this week by noting that thanks to the new FX regime (which, in theory anyway, should have required less intervention),<strong style="box-sizing: border-box;">China has <a href="http://www.zerohedge.com/news/2015-08-25/devaluation-stunner-china-has-dumped-100-billion-treasurys-past-two-weeks" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; outline: none; text-decoration: none;" target="_blank">likely sold</a> somewhere on the order of $100 billion in US Treasurys in the past two weeks alone </strong>in open FX ops to steady the yuan. Put simply, as part of China’s devaluation and subsequent attempts to contain said devaluation, China has been purging an epic amount of Treasurys.</div>
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But even as the cat was out of the bag for Zero Hedge readers and even as, to mix colorful escape metaphors, the genie has been out of the bottle since mid-August for China which, thanks to a steadfast refusal to just float the yuan and be done with it, will have to continue selling USTs by the hundreds of billions, the world at large was slow to wake up to what China’s FX interventions actually implied until Wednesday when two things happened: i) Bloomberg, citing fixed income desks in New York, noted “substantial selling pressure” in long-term USTs emanating from somebody in the “Far East”, and ii) Bill Gross asked, in a tweet, if China was selling Treasurys.</div>
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Sure enough, on Thursday we got confirmation of what we’ve been detailing exhaustively for months. Here’s <a href="http://www.bloomberg.com/news/articles/2015-08-27/china-said-to-sell-treasuries-as-dollars-needed-for-yuan-support" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; outline: none; text-decoration: none;" target="_blank">Bloomberg</a>:</div>
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<strong style="box-sizing: border-box;"><em style="box-sizing: border-box;">China has cut its holdings of U.S. Treasuries this month to raise dollars needed to support the yuan in the wake of a shock devaluation two weeks ago, according to people familiar with the matter.</em></strong></div>
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<em style="box-sizing: border-box;">Channels for such transactions include China selling directly, as well as through agents in Belgium and Switzerland, said one of the people, who declined to be identified as the information isn’t public. <strong style="box-sizing: border-box;">China has communicated with U.S. authorities about the sales,</strong> said another person. They didn’t reveal the size of the disposals.</em></div>
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<em style="box-sizing: border-box;">The latest available Treasury data and estimates by strategists suggest that China controls $1.48 trillion of U.S. government debt, according to data compiled by Bloomberg. That includes about $200 billion held through Belgium, which Nomura Holdings Inc. says is home to Chinese custodial accounts.</em></div>
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<em style="box-sizing: border-box;"><img alt="" class="img-responsive" height="344" src="http://www.zerohedge.com/sites/default/files/images/user92183/imageroot/2015/08/ChinaUSTHoldings.png" style="border: none; box-sizing: border-box; display: block; height: auto; max-width: 100%; outline: none; vertical-align: middle;" width="353" /></em></div>
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<em style="box-sizing: border-box;"><strong style="box-sizing: border-box;">The PBOC has sold at least $106 billion of reserve assets in the last two weeks, including Treasuries, according to an estimate from Societe Generale SA. </strong>The figure was based on the bank’s calculation of how much liquidity will be added to China’s financial system through Tuesday’s reduction of interest rates and lenders’ reserve-requirement ratios. The assumption is that the central bank aims to replenish the funds it drained when it bought yuan to stabilize the currency.</em></div>
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Now that what has been glaringly obvious for at least six months has been given the official mainstream stamp of fact-based approval, the all-clear has been given for rampant speculation on what exactly this means for US monetary policy. Here’s Bloomberg again:</div>
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<em style="box-sizing: border-box;">China selling Treasuries is “not a surprise, but possibly something which people haven’t fully priced in,” said Owen Callan, a Dublin-based fixed-income strategist at Cantor Fitzgerald LP. <strong style="box-sizing: border-box;">“It would change the outlook on Treasuries quite a bit if you started to price in a fairly large liquidation of their reserves over the next six months or so as they manage the yuan to whatever level they have in mind.”</strong></em></div>
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<em style="box-sizing: border-box;">“By selling Treasuries to defend the renminbi, <strong style="box-sizing: border-box;">they’re preventing Treasury yields from going lower despite the fact that we’ve seen a sharp drop in the stock market,</strong>” David Woo, head of global rates and currencies research at Bank of America Corp., said on Bloomberg Television on Wednesday. “China has a direct impact on global markets through U.S. rates.”</em></div>
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As we discussed on Wednesday evening, we do, thanks to a review of the extant academic literature undertaken by Citi, have an idea of what foreign FX reserve liquidation means for USTs. “Suppose EM and developing countries, which hold $5491 bn in reserves, <strong style="box-sizing: border-box;">reduce holdings by 10% over one year – this amounts to 3.07% of US GDP and means 10yr Treasury yields rates rise by a mammoth 108bp ,”</strong> Citi said, in a note dated earlier this week.</div>
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In other words, for every $500 billion in liquidated Chinese FX reserves, there’s an attendant 108bps worth of upward pressure on the 10Y. Bear in mind here that thanks to the threat of a looming Fed rate hike and a litany of other factors including plunging commodity prices and idiosyncratic political risks, EM currencies are in free fall which means that it’s not just China that’s in the process of liquidating USD assets.</div>
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<a data-slb-active="1" href="http://www.zerohedge.com/sites/default/files/images/user92183/imageroot/2015/08/20150826_EMFX.jpg" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; outline: none; text-decoration: none;" target="_blank"><img alt="" class="img-responsive" height="300" src="http://www.zerohedge.com/sites/default/files/images/user92183/imageroot/2015/08/20150826_EMFX_0.jpg" style="border: none; box-sizing: border-box; display: block; height: auto; max-width: 100%; outline: none; vertical-align: middle;" width="600" /></a></div>
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The clear takeaway is that there’s a substantial amount of upward pressure building for UST yields and that is a decisively undesirable situation for the Fed to find itself in going into September. On Wednesday we summed the situation up as follows: “one of the catalysts for the EM outflows is the looming Fed hike which, when taken together with the above, means that if the FOMC raises rates, they will almost surely accelerate the pressure on EM, triggering further FX reserve drawdowns (i.e. UST dumping), resulting in substantial upward pressure on yields and prompting an immediate policy reversal and perhaps even QE4.”</div>
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Well now that China’s UST liquidation frenzy has reached a pace where it could no longer be swept under the rug and/or played down as inconsequential, and now that Bill Dudley has <a href="http://www.zerohedge.com/news/2015-08-26/dudley-says-we-are-long-way-additional-qe" style="background: transparent; border: none; box-sizing: border-box; color: #025ab4; outline: none; text-decoration: none;" target="_blank">officially opened the door</a> for “additional quantitative easing”, it would appear that the only way to prevent China and EM UST liquidation from, as Citi puts it, “choking off the US housing market,” and exerting a kind of forced tightening via the UST transmission channel, will be for the FOMC to usher in QE4.</div>
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From: Zero Hedge</div>

CONFIRMED: CHINA LIQUIDATING TREASURIES, WARNS WASHINGTON

On Tuesday evening, we asked what would happen if emerging markets joined China in dumping US Treasurys. For months we’ve documented...

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