“Asia’s importance in the bond market cannot be overstated”
That quote doesn’t come from me — but from someone with a bit more authority: Jim Caron, co-head of global interest rate strategy at Morgan Stanley (quoted by Michael MacKenzie in Monday’s Financial Times). Interestingly enough Caron’s estimate of the impact of Asian [read central bank] demand on yields is lower than some other academic and market estimates – he puts the impact at around 60 bp.
Caron’s quote ranks up their with one of my other favorite quotes from the past few weeks — Kevin Giddis of Morgan Keegan and Co argued that, for the bond market, China’s investment in Blackstone was like “kind of like the butcher finding out his best customer…is now a vegetarian.” (as reported by Michael Hudson on May 29th)
I actually don’t think China is close to becoming a bond market vegan. Not with a $22.4b monthly trade surplus and close to 30% y/y export growth in May. China’s trade surplus, current account surplus and reserves are all rising strongly this year. Fan Gang — who is in a position to know – is now predicting China’s reserves could hit $1.6 trillion in 2007, and top $2 trillion in 2008.
The $3b China invested in the Blackstone is roughly equal to my estimate of China’s average bond purchases over any two working days: Think $40b a month in reserve growth, $30b in a month in dollar purchases, 20 working days a month …
The pace of China’s reserve growth has essentially doubled over the past year, rising from $20b a month to around $40b a month this year. Justin Lahart’s take on Blackstone — “if you are paying for the fuel, you might as well get some of the heat ” — was perfect. Right now, China can buy a “Blackstone stake” a month AND still buy far more bonds every month than it did in 2005 or 2006.
I don’t see many other Asian economies adopting bond-free all vegetable diets either. All indicators suggest Asian economies are still adding to their reserves quite actively. India added $3.5b to its reserves in the last week of May. Korea has been buying dollars steadily over the past month. Malaysia has intervened all year long — at least until the past week or so, when private inflows turned to outflows.
Indeed, the possibility that the bond conundrum might come to an end at a time when Asian reserve growth seems to be far closer to a peak than to a through is sort of a conundrum for those — myself included — who thought Asian (and petro-state) reserve growth was the fundamental cause of the conundrum.
That is probably why I really liked Mackenzie’s FT article. He argues that the Asian bid for long-term bonds disappeared in large part because Asian central banks started buying the short-end of the curve.
Compounding matters was a distinct lack of Asian buyers at the sales of new Treasury debt in May. MacKenzie:
The markets had come to expect heavy purchases by Asian central banks and their absence left Wall Street dealers holding bonds.
“The auctions were extremely weak and Asian buyers preferred Treasury bills [with maturities of less than one year] rather than the 10-year,” said Tom di Galoma, head of Treasury trading at Jefferies & Co. “We rose above 4.78 per cent and there were no buyers, then we went above 4.9 per cent and people expected that would be the high for this year.”
Early last week, the yield on the 10-year threatened to break above 5 per cent and many investors expected such a move would finally attract buyers, particularly from the hitherto quiet Asian accounts.
But it seems Asian accounts (meaning China? Is anyone else half as a big a player?) stayed on the sidelines. Bond yields broke 5.02 — a huge trend line — and then, well, things really started to move.
The Mackenzie story isn’t inconsistent with a story that emphasizes changing expectations about the Federal Reserves likely rate path as a core driver of the bond market, or even with a story that emphasizes the impact of stronger global growth on US rates. The shift in overall interest rate expectations just had an impact when the expectations on Asian accounts — read central banks — shifted. Once Asian central banks decided that they preferred the short-end of the curve (with its higher yields) to the long-end of the curve (with lower yields but the prospect of gains should rates fall), long-term rates had to rise.
If this story is true, it supports — rather than contradicts — the thesis that central bank demand has had a meaningful impact on US rates. Central banks take a week or two off. Rates gap up. Private market participants (Caron of Morgan Stanley) who were betting on the central bank bid had to reverse course. The FT reports that Caron went from buying at 5% (in the hope of selling to Asian central banks) to selling at 5.02% …
We don’t really have a good fix on just how important China has been to the Treasury and Agency market over the past year. Or at least those of us who work off the US data rather than the flows going through investment banks don’t have a good fix on the scale of Chinese purchases. The last survey showed about $190b in Chinese purchases of long-term debt (mostly Treasuries and Agencies), and net Chinese sales of short-term US debt. If you read between the lines of the latest survey data, it is pretty clear that China was more or less the only big official buyer of “Agency MBS” — MBS with an agency guarantee — between June 2005 and June 2006. (See table 4 on p. 12: total official holdings of Agency MBS are $118; total Chinese holdings are $107b). China doesn’t just impact the Treasury market.
But that $190b flow came when Chinese reserve growth was tracking at about $250b (on a lagging 4 quarter basis). It is now tracking at about $350b (looking back) — perhaps a bit more if you think a lot of the 100b plus in Chinese purchases of debt securities in the 2006 balance of payments represents state banks playing with dollars borrowed from the central bank. And looks set to rise even more through the end of the year.
When the survey data for June 2006 to June 2007 comes out, my guess is that total Chinese purchases will be north of $250b. And based on the anecdotes reported in the FT, I wouldn’t be totally surprised if China end up adding to its short-term holdings, not cutting them.
But if others have a different take, I am all ears.
I put this graph up over the weekend, but it fits here too — and more people tend to read this blog during the week than on the weekend. It shows various measures of central bank demand for US bonds. It is hard for me to think that central bank demand for US securities has disappeared entirely when overall reserve growth remains so strong.
A host of models predicted — based on variables like inflation rates and the US fiscal deficit and the like – bond yields of around 6%. There was a large gap between market rates and the rates that emerged from the models when US rates were close to 4.5%. But the gap remains even with rates at around 5%. Look at chart 13 in this Sebastian Becker/ Deutsche Bank report (Hat tips, Mikka Pineda and Global Liquidity Blog; chart 15 is also interesting). Nominal bond yields usually track nominal GDP growth relatively well. But recently they have been below nominal GDP growth in both the US and Europe. The gap has fallen in the US largely because nominal GDP growth has fallen — not, until recently from a rise in nominal bond yields. A recent Goldman research report also showed that its bond models still find US rates lower than the model would expect. Even at 5%. Credit Agricole’s analysis also implicitly suggests that rates should be much higher. They put the conundrum at over 100 bp earlier in the year. US rates have increased since then, but not by 100 bp.
I don’t think the conundrum isn’t over. Not yet. The US is still financing a very large external deficit at a relatively low rate.
UPDATE: In today’s Wall Street Journal, TJ Marta of RBC Capital Markets is quoted to the effect that Asian central banks have been big buyers of long-dated Treasuries:
“T.J. Marta, fixed-income strategist at RBC Capital Markets, expects longer-term yields to continue to move higher for three reasons: investors abandoning the notion of the Federal Reserve needing to cut rates to shore up weakness in housing; increasing investor sensitivity to global inflation; and a waning of foreign buying interest, particularly in Asia, for Treasurys.
The latter two reasons are particularly bad news for long-dated bonds. They have been the main area of interest for Asian buyers and they suffer most from inflation worries, as inflation eats into bondholders’ fixed returns over time.”
The rally in Treasuries that started last summer coincided with, I think, a pick up in central bank demand for longer-dated bonds, as central banks concluded the Fed’s rate hiking cycle was over and began to bet that the US was set to slow and the Fed would be forced to cut. The evidence here is mostly anecdotal, but there also was a fall off in the growth of central bank dollar deposits in the second half of 2006. While I have a hard time finding evidence that central bank demand for dollars has fallen recently, central bank demand for long-dated dollar bonds could have fallen.
29 Responses to ““Asia’s importance in the bond market cannot be overstated””
df • June 12th, 2007 at 3:44 am
If China is finally realising that it will have to let the RMB rise, it is natural that they move for the short term maturity bonds. Is n it ?
The US rates are not much higher than the european ones and China may have to rise its own again.
If the US rates move higher they may attract more capital, but with what effect on the housing market ?
This seems more and more like zuckswang …
RebelEconomist • June 12th, 2007 at 4:55 am
It might be more appropriate to say that the impact on the bond market of China’s purchase of a stake in Blackstone is more like the greengrocer finding out that his best customer has become a carnivore!
jkh • June 12th, 2007 at 5:13 am
Presumably the various models contend that CBs drive bond yields below the expected Fed rate path. Do they explain CB willingness to incur a 60 or 100 basis point cost to buy bonds in the wake of such apparently irrational (according to the models) and self-destructive pricing behavior? There are plenty of alternatives for permanent investment in short dated maturities, where the risk of the deviations from the expected Fed path would be obviated by interest rate sensitivities that correlate more closely to the actual Fed rate path – not only treasury bills and short dated government bonds, but bank deposits, of which there are trillions outstanding.
Guest • June 12th, 2007 at 6:24 am
and everyone thought it was pimco, cuz gross was on tv; what’s kinda interesting to me is that the big moves happened overnite rather than in new york…
Charlie • June 12th, 2007 at 7:13 am
I suspect China’s USD peg has a much bigger effect on interest rates than anyone has stated. China’s peg forces other CB’s to buy a lot of debt that they otherwise wouldn’t buy. Mainly asian CB’s. I don’t think it has much effect on middle east peggers.
I wonder if higher US rates will cause an increase in the Yen carry trade. If so, the Yen will drop in value and may force China to get back into US debt buying to force interest rates back down and the Yen back up.
It’s going to be an interesting summer.
jkh • June 12th, 2007 at 7:16 am
If CBs systematically overprice bonds, then they should systematically overprice them in any market, regardless of volatility. This is inherent in the meanings of systematic risk and volatility risk. The recent increase in yields at its core reflects a change in Fed rate expectations. That change flows through directly to CB behavior at bond auctions. But it shouldn’t affect systematic overpricing according to the core thesis of the CB effect. The entire rate structure has simply moved up – the underlying ‘normal’ rate structure implied by the models of the CB effect, and the actual rate structure due to the CB presence. In other words, the spread between actual rates and ‘ex-CB normal’ rates as implied by the models should not necessarily change because of this latest move.
bsetser • June 12th, 2007 at 7:40 am
jkh — you are right; a change in fed expectations would tend to push up rates, with central banks holding the rate down relative to the new expected fed path. the war stories from the trading floor are secondary — they are just the mechanism through which that adjustment took place. what struck me as interesting about the mackenzie story is that “Asian names” didn’t come in when some in them market expected them to come in, and that contributed to the violence of last week’s move.
central banks generally were expected not just to hold rates down but to dampen volatility, and they didn’t do either. tho arguably expectations of central bank actions kept rates well below the expected fed path for a very long time, creating the basis for a big move.
but then again i may be drawn to war stories that seem consistent with my prior beliefs.
I think the bigger question is whether the “central bank bid” is itself a manifestation of something else. it clearly reflects the global savings glut (such as it exists) since the central banks that are accumulating reserves tend to be in “glut” countries — whether China or the oil exporters (China’s glut is growing, the oil exporters’ glut is falling). Though as more and more central bank reserve growth reflects capital inflows from the center not savings in the periphery, the correlation between “Reserves” and “excess savings” weakens (see Russia, whose reserve growth has gone up as its current account surplus has gone down).
It arguably reflects weak global growth (reserve accumulation and resistance to appreciation stems from domestic weakness)–but here it is hard to construct a story that leads to a big move (nothing dramatic changed on the global growth front last week). The path of interest rates globally looks a bit higher, but not dramatically so. Moreover, the argument that reserves reflect low growth doesn’t fully fit the facts: big reserve accumulators right now are growing rapidly, not slowly, and some have plenty of demand growth (Russia on the demand side, china on the rapid growth side, tho supply still outpaces demand).
Emmanuel • June 12th, 2007 at 9:01 am
But if others have a different take, I am all ears.
I’m sure most of you have heard of this, but Baucus-Grassley-Schumer-Graham is going to be unveiled tomorrow right before Treasury reports to Congress on currencies. Odds are that China will again not be declared a currency manipulator based on Treasury’s statements. So, it’s time for Senate action.
CBs are staying on the sidelines to see just how hard the Senate will whack China. In turn, China has already promised retaliation if the bill means higher tariffs on Chinese exports to the US. Given the potential fracas, CBs incur smaller risks while waiting by buying Treasuries at the short end rather than at the long end of the yield curve. I know, CBs have been insensitive to rates thus far, but this might be the action that finally gets some trade war rolling. That’s my explanation of why CBS have been buying more at the short end. Prepare yourselves for possible whiplash…
Guest • June 12th, 2007 at 9:22 am
“…Mr Mandelson, a critic of protectionism, will tell Bo Xilai, China’s commerce minister, that he and the European commission as a whole are under growing pressure from governments and businesses to ensure that Beijing delivers on its promises of reciprocity and removes artificial barriers to entering Chinese markets… Europe, China’s biggest trading partner, exports more to Switzerland than it does to China…” http://business.guardian.co.uk/story/0,,2100815,00.html
Guest • June 12th, 2007 at 9:33 am
re: “Asian names” didn’t come in when some in them market expected them
Any chance China may have been busy (perhaps selectively) supporting commodity prices?
“China is making a big bet on the future strength of copper prices, with the country’s largest state-owned mining company offering $840-million for Vancouver’s Peru Copper Inc….” http://www.globeinvestor.com/servlet/story/GAM.20070612.RPERU12/GIStory/
Guest • June 12th, 2007 at 9:40 am
so is this where everyone lays their hand down on the table or does everyone check again while the blinds go up?
RebelEconomist • June 12th, 2007 at 9:42 am
As jkh says, bank deposits provide a ready alternative to treasuries for central banks, for the short term at least. Perhaps the Chinese are just holding their intervention proceeds in bank deposits for a while as a demonstration to the Senate, in view of the events tomorrow mentioned by Emmanuel.
According to the Financial Times, the Senate are intending to mandate the Treasury to intervene where currencies are “misaligned”, but their options for dealing with the renminbi are limited:
http://www.ft.com/cms/s/3c4a9ed0-1625-11dc-a7ce-000b5df10621.html
AC • June 12th, 2007 at 10:57 am
The bond yields are going up, which means that there is less demand for US debt. This should lead to a fall of the USD, eg. against the euro. But recently the USD is rising against the euro, so somebody (China obviously among them) is buying USD. So, where is all this dollar if it is not in bonds?
Guest • June 12th, 2007 at 11:37 am
“Global rebalancing requires exchange rate as well structural adjustments. There are hints of rebalancing in the global economy, like America’s slowly narrowing current account deficit, China’s attempts to cool the pace of economic expansion, and even an increase in real interest rates. As a result, ‘excess’ liquidity — measured by money supply growth minus GDP growth in G5 countries and China — eased from an average of 4.3% between 2002 and 2005 to 0.5% at the end of last year. However, we believe that the explosive growth in derivatives has weakened the link between monetary aggregates and market liquidity. Therefore, the world economy still needs structural adjustments as well as proactive policy updates (like currency revaluation in Asia and oil-exporting countries) to stay on a sustainable growth path.” http://www.morganstanley.com/views/gef/archive/2007/20070612-Tue.html#anchor5035
Emmanuel • June 12th, 2007 at 12:25 pm
Rebel–I too am puzzled by how the China currency bill will work. WTO membership does put limits on what can be done with regard to tariffs. However, an earlier FT article described a convoluted path. First, the US will go to the IMF and ask it to determine just how much the yuan is undervalued. Next, the US will ask the WTO for appropriate sanctions to offset the level of undervaluation determined by the IMF.
As I said, it’s convoluted and I doubt whether that’s how the bill will work. I see something more alike a “conditionality” scheme of gradually tightening trade and non-trade barriers if China refuses to allow the yuan to float. We shouldn’t bother to think about it too much as we’ll see whether it’s the “real deal” by tomorrow. The implication is clear from my POV: higher long-term yields Stateside.
cmc313 • June 12th, 2007 at 12:31 pm
Here’s a conspiracy theory: could China be slowing its purchase of treasury to send a message to the Congress that they can retaliate against protectionist measures now proposed in Chuck Schumer and others on both side of the aisle? We may got what we wish for — China slows down purchase of treasury and out rate spikes up…we force them to revalue and as a result our inflation flares up…then rates go up more…
Be careful what we wish for!
bsetser • June 12th, 2007 at 12:44 pm
I am a big fan of Cevik. I would though distinguish between the rise in real rates in the center — US and Europe — and the fall in real rates in the capital exporting periphery (Gulf, Russia, China) as inflation there has increased faster than rates. that is pro-rebalancing (low real rates = positive for demand growth in china,gulf, russia), but as of now, i still more evidence of adjustment in the gulf/ russia (their surpluses are shrinking even with relatively high oil prices) than in China.
RebelEconomist • June 12th, 2007 at 1:01 pm
Emmanuel
I followed the link to your blog, but found I could not comment there. One source of confusion may be the FT’s loose use of the term “intervention”.
Macro Man • June 12th, 2007 at 1:57 pm
Re: the Senate bill, the obvious missing link is how you intervene to buy a non-deliverable, capital controlled currency. Maybe the US Treasury should issue RMB or dual-currency bonds to allow speculators to buy the RMB that PBOC won’t allow them to buy…
bsetser • June 12th, 2007 at 2:10 pm
Macroman is right —
and if China allowed foreigners to bet on the RMB, i suspect private investors would do exactly what the congress wants the treasury to do — i.e. buy RMB and force the PBOC to sterilize more.
Emmanuel • June 12th, 2007 at 3:39 pm
Macro Man: I doubt whether Messrs. Grassley, Baucus, Schumer, and Graham are knowledgeable about using NDFs! Interesting suggestion, though.
I am at fault for not mentioning this, but the proposed bill is not really just about China. It’s about undervalued currencies in general as these guys are thinking “sure it’s China now, but who will it be in the future?”
I doubt whether US action with regard to China will involve “intervention” in the sense of open market operations a la New Zealand. Rather, it will involve justifying tariff escalation in a manner consistent with WTO rules. What’s potentially new here is that there’s no real precedent on cases of currency undervaluation in the WTO.
Perhaps it’s time to lighten up on those yen shorts, carry traders. The days of “special FX” may be numbered.
AC • June 12th, 2007 at 4:04 pm
I would like to ask again: if bond yields are going up, and the dollar is steady or strenghtening, then where all those huge dollar reserves (around 100 billion by Brad’s estimate) went in the past month?
Guest • June 12th, 2007 at 4:09 pm
Villains and victims of global capital flows
There are two alternative explanations for the state of the world economy: a money glut and a savings glut… It is no surprise that the Federal Reserve is a believer in the savings-glut hypothesis. But many Asians blame their present predicament on “dollar hegemony”, which is the core of the “money-glut” hypothesis. The big questions, however, are which is true and whether it matters.
My answer to the first is that the savings-glut hypothesis is truer… My answer to the second is that indeed it does matter. If we live in the savings-glut world, the US current account deficit is protecting the world from deep recession. If we live in the money-glut world, that very same deficit is threatening the world with a dollar collapse and, ultimately, even a return of worldwide inflation.
The savings-glut view is far more comforting. Excess savers will learn to spend, in the end – sooner rather than later, if US spending were to weaken dramatically. But if we live in the money-glut world, the great gains in monetary stability of the past quarter century are at risk.
Either way, the present world cannot continue indefinitely. Moreover, either way, it makes little sense for emerging-market economies to write a blank cheque to the US. The era of massive currency intervention and dependence on excess spending by US households must end. Might that end be nigh?
Guest • June 12th, 2007 at 4:37 pm
re: “excess spending by US households” – does anyone really believe, or been able to quantify/qualify this?
bsetser • June 12th, 2007 at 6:59 pm
AC — good question. short-term deposits? short-term paper?
or may i have over-estimated reserve growth.
RebelEconomist • June 13th, 2007 at 3:39 am
Macro Man,
Why do you say the renminbi is a “non-deliverable” currency rather than “non-convertible”, as the letter to the FT linked above puts it?
I cannot see why it would help the US to issue renminbi bonds. If the renminbi was indeed deliverable/convertible, intervention by the US would involve buying renminbi bonds. I am sure that such bonds would be eagerly bought by the private sector though!
The NDF market does offer the US some scope to intervene to push up the renminbi, but I doubt that it has sufficient depth to support much intervention. Ultimately, some party needs to be willing to sell the renminbi side of the NDF, and there will not be many who are prepared to do this without buying onshore renminbi assets, and therein lies the problem – the restricted capital account.
Guest • June 13th, 2007 at 8:13 am
“…”I’m expecting further gains in the dollar on the yield differential” said Tony Morriss, a currency strategist at Australia & New Zealand Banking Group Ltd. in Sydney. “U.S. yields against Europe have had really big moves.” The dollar traded at $1.3279 per euro from $1.3302, the strongest since March 26. The euro extended losses as European stocks fell on concern rising bond yields will hurt profit growth and erode demand for equities… The dollar may also be supported as a Commerce Department report today will probably add to evidence of a recovering U.S. economy…” http://www.bloomberg.com/apps/news?pid=20601087&sid=azCU2Ljf9GJw&refer=home
Guest • June 13th, 2007 at 8:40 am
“…People with inside information may use options, futures, and private contracts derived from stocks, bonds, currencies and commodities that may be harder to trace…” http://www.bloomberg.com/apps/news?pid=20601087&sid=a0Le7f.KNDos&refer=home
tmcgee • June 14th, 2007 at 5:34 pm
yeah, the anecdotes floating around are that china has shifted money into the short-end of the UST curve that’s causing some distortions in TED spreads. i also wonder just what the PBOC’s raising of interest rates, past and prospective, affects how they manage the USD reserves. maybe the higher short-term US rates make it more advantageous to get returns there than the 10-year sector? this is pure hunchwork, nothing terribly well thought out.
