Markets Debates Drivers of US Treasuries

Markets Debates Drivers of US Treasuries

  • There is growing speculation that China is selling US Treasuries during its FX operations, which is driving up yields in the US; but the reality may be more prosaic
  • UK preliminary GDP came in right on expectations at 2.6% y/y for Q2
  • The data out today will be secondary to the speech by Fed Vice Chair Fischer tomorrow at Jackson Hole
  • Aside from talk of official support for the equity markets, at least two other headlines helped underpin the rebound in Chinese equities

Price action: The dollar is mostly weaker on the day, but trading in narrow ranges. The euro touched $1.1120 but has since bounced back closer to $1.1300. Sterling is trading on both sides of $1.54. The dollar is down against the Swedish krona and the Japanese yen, at SEK8.4250 and ¥120.80 respectively, but not making any new ground. Performance has been mixed on the EM side. THB, MXN and ZAR are giving up some of yesterday’s gains, but KRW and MYR are up against the dollar. Of note, the dollar is back below CNY 6.4 level against the yuan after a 0.2% appreciation. Asian equity markets continued to rebound with the Shanghai Comp up nearly 5.0%, Taiwan up 2.5% and the Nikkei gained 3.0%. EuroStoxx is down 0.4%, a small move considering it was up 3.5% yesterday. US futures are down 0.6%. US Treasury yields are down 4 bp overnight across the curve with 10-year yields at 2.15%, holding up above the 200-day MA around 2.13%.

  • US 10-year Treasury yields has risen 25 bp since Monday’s low water mark, sparking speculation that China is selling.  There are a number of reports that try to link the backing up in US yields to be sales of Treasuries by China. The Chinese sales, in turn, are linked to its efforts to stem the decline in the yuan. China may indeed have sold Treasuries. Reporters and high profile investors have been keen to follow the lead.  Some media accounts intimate that China had notified US officials of their intentions, even before this week.   China’s reserves have fallen.  China owns a lot of Treasuries.  Therefore, it follows that China likely sold Treasuries.
  • However, the situation is more complicated.  For example, the dollar value of China’s reserves fell by $113 bln in Q1 and another $37 bln in Q2.  According to the US TIC data, China’s Treasury holdings rose by $17 bln in Q1 and another $10 bln in Q2. Reporters, following the lead of a couple of analysts, argue that China is operating in other centers that the TIC data does not fairly attribute to China.  But to make their numbers work, for example, they assume that the entire decline in Belgium’s holdings (Euroclear) is a result of China.  This assumption is unwarranted.  There are other pools of capital that use financial centers like Belgium and Switzerland for financial transactions.  Some Middle East oil producers, for example, have also reported declines in reserves.
  • There are two forces that can help explain at least part of the decline in China’s reserves.  The first, most important, and often left out, is valuation.  It is not fair to discuss the change in China’s reserves without adjusting for valuation.  The second adjustment in China’s reserves that few accounts attempt to incorporate is the official indication that some reserves have been transferred to other parts of the government, including the development bank and the export-import bank.  Admittedly, exactly how China is accounting for this is opaque, but to ignore it entirely does not seem right either.
  • Of course, there is still room in the data for China to have sold Treasuries, but one has to do more than tease the data, and as we know, sufficiently tortured data will admit to anything.   The latest claims of China Treasury selling are too recent to be picked up in the TIC data (only through June) and China’s reserve figures (through July).   Yet there seems to be a more convincing explanation than China to explain the rise in the 10-year US Treasury yield in recent days.
  • First, as we argued last weekend and at the start of this week, the global capital markets had an exaggerated response to macro-economic developments. This is the case with the minor depreciation of the yuan, leaving it slightly less strong, but hardly weak.  The 10-year yield spiked to 1.90% as part of that exaggeration.  Recall the Dow Jones Industrials posted 1000 point loss on Monday.  Although some reports confused a short covering rally in the euro with safe haven demand (there is a difference between reducing shorts and expanding longs), US Treasuries were the time-tested safe haven.  As the panic subsided, so did the demand for Treasuries.
  • Second, speculators in the futures market likely sold into the rally.  On August 11, the same day that China devalued the yuan, speculators had held 500k gross long 10-year Treasury futures (each contract has a notional value of $100k).   This was the most since 2008.  In the following week (ending August 18), 46k contracts were liquidated.  This was the largest sales in three months.  Speculators had been net short US 10-year Treasury futures since last September.  They switched to a new long position in mid-July after the 2.50% threshold remained intact.    However, they seemed eager to sell into the bond market rally.  New data for the week through August 25 will be made available tomorrow.
  • Third, the economic data shows that there has been little immediate impact on the US economy from the first the drop in Chinese stocks and then from the depreciation of the yuan.  Of course, it is only prudent to recognize the possibility of economic and financial lags.  Nevertheless, all else being equal, the strength of some recent data, leading to expectations that Q2 GDP would be revised up (it was and by more than expected), coupled with signs of a pickup in US consumption and business investment would have likely produced some selling pressure on the US Treasuries regardless of what was happening in Beijing. After today’s PCE data, the next key report is August jobs data.  ADP may steal some of the thunder of the national report.
  • Aside from talk of official support for the equity markets, at least two other headlines helped underpin the rebound in Chinese equities. First, a statement by the Ministry of Commerce said the government would lower the threshold for foreign capital to participate in the domestic property markets. Second, the Ministry of Finance decided to further expand the local government swap program to RMB3.2 tln from RMB2.0 tln. There was some talk the funds used to support equity prices will be replenished. The Shanghai Comp is up 4.8%.
  • In the currency market, the PBOC fixed the dollar at CNY6.3986.  This was 0.15% lower than the previous day.  The dollar had finished the Shanghai session on Thursday near CNY6.4015. As we suggested previously, the key under the new currency regime is not between the two fixings as had been previously the case, but between the spot close and the next day’s fix.   It appears that in order to ensure convergence it is not sufficient to intervene in the spot market.  There needs to be a convergence between the forward rate implied and the actual money market rates. There are reports suggesting that a couple policy banks have been used to intervene in the swaps market to help bring the rates more into line.   Chinese officials appear to be still trying to implement the August 11 decision about the new currency mechanism.
  • Looking at the data overnight, UK preliminary GDP came in right on expectations at 2.6% y/y for Q2. Net trade were a highlight, adding 1.2 percentage points to the headline rate. Business investment also accelerated. Euro-area economic confidence came in at 104.2 for August, stronger than the 103.8 expected, while the final reading for August consumer confidence ticked lower to -6.9 from -6.8. In Spain, CPI came in lower than expected. The preliminary harmonized CPI for august came in at -0.5% y/y, down from 0.0% previously, but lower energy prices are playing a large role, hence maybe masking the more positive underling trend. Greece grew 0.9% q/q in Q2, with final consumption up 1.1%, exports up 0.1%, and imports down 2.3%. Seasonally adjusted, GDP grew 1.6% y/y. Lastly, Switzerland released its Q2 GDP at 1.2% y/y, better than the 0.9% expected. With a q/q growth of 0.2% (vs. -0.1% expected), this means that the country was technically not in recession as had thought after investment and private consumption helped boost growth in the quarter.
  • In Japan, the national CPI print for July came in as expected at 0.2% y/y. The core reading, excluding fresh food and energy remained stable at 0.6%. Also note that household spending surprised on the downside at -0.2% y/y compared with expectations for a bounce back into positive territory of 0.5%. However, retail sales surprised on the upside rising to 1.6% y/y in July from a revised 1.0% in the previous month. All in all, the data doesn’t bode well for the BoJ’s target and will continue fuelling calls for further action, despite recent comments by Governor Kuroda to the contrary. We think the market may be overestimating the chance of imminent action.
  • The main forthcoming event for US and probably global markets will be the speech by Fed Vice Chair Fischer when he speaks tomorrow at Jackson Hole. He will be speaking on inflation. As we noted previously, we will be looking for him to elaborate on how the Fed targets core inflation, and why the appreciation of the dollar, and drop in commodity prices, have a transitory impact on the general price level. After Dudley’s comments, markets will be carefully looking for any discussion on the recent market volatility and signs that the committee may be shifting its preference to a later hike.
  • Out of the US today we get personal income and spending, PCE, and University of Michigan survey. Markets expect a personal income gain of 0.4% in July, the same as last month, and a tick up in spending to 0.4% from 0.2%. Core PCE is expected to remain steady at 1.3% y/y for July, close to the lows of the year. Meanwhile, the University of Michigan survey is seen as ticking higher in its final reading to 93.0.