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In a span of less than 24 hours, we went from a Bloomberg News report last week that China might reduce its exposure to US Treasuries to China’s denial and claims of ‘fake news.’ I suspect the original story and the denial had official backing, with the initial news viewed as a “temporary truth†that would dissipate like a Snapchat photo after a brief period of time to be replaced by a more convenient truth. That said, the run-up in Treasury yields before the news means that China may, in fact, have been hedging some of its portfolio holdings.
Yields have since gone up and the dollar down against the euro, suggesting the market believes there’s some merit to the notion that China wants to pull back from its massive holdings of US financial assets. The thinking is, China is probably flirting with a bit of dollar-based asset selling not only in an attempt to strengthen its hand in trade negotiations, but also to get a better understanding of how these financial weapons would work. It’s the same reason you test nuclear weapons — to see what they can do.
There are two problems with this scenario. If the euro is rising because China is buying financial assets in the region, then nominal euro-zone bond yields should not have gone up more than US bond yields since January 9, the day before the Bloomberg story. Euro-zone real, or inflation-adjusted, rates have also gone up more than US real rates since early December, making it hard to see a portfolio shift in these relative price changes.
And though Federal Reserve data show a $39 billion drop in its custody holdings on behalf of foreign central banks and institutions since early December, the decline would have been much sharper if the word was out among currency reserve managers that it was time to sell. Custody holdings — and to be clear, I don’t think much of China’s reserves are held in custody by the Fed — are still up $189 billion from a year earlier.
The bigger question is: Who would get shot in the foot because of a Chinese pullback, and who would be doing the shooting? Since US real rates are essentially flat in recent months, it’s hard to say that China’s withdrawal has led to higher effective US borrowing costs. Equity markets are certainly not seeing any pain. The drop in the dollar is not only contributing to the gains in asset markets, but making the US more, rather than less, competitive. A weak dollar is trade policy by another name. The drop might not help solar panel manufacturers much, but the benefits accrue to a much wider swath of trade-exposed industries. The Trump administration is not even putting on much of a show about caring about the dollar’s
depreciation.
China’s holding of US Treasuries and, by extension, its financing of the US budget deficit, should be viewed as hostage-taking to ensure mutually good behavior: The US doesn’t do anything that attacks China too hard on the trade front, and China doesn’t dump its Treasuries and push US borrowing costs skyward. China’s large holdings of Treasuries are a reflection of its large trade surpluses with the US The same goes for many other holders of dollar reserves.
China’s current-account surplus is also its financial account deficit, and sometimes it is hard to tell which is driving which. It may look as if the US is offering worthless paper in return for solar panels and washing machines, but the paper carries security of ownership and a reliable legal and institutional framework. These are highly desirable for private investors.
Reserve manager diversification out of dollar-denominated assets is often discussed as if such a thing is feasible without a major market impact. Between the US and its major trading partners and asset holders, the amounts in question are so large that is not possible. Any retaliatory financial-market bullet China sends in the US direction is likely to go through two victims, and it’s not clear which will suffer more damage.
This is not an issue of right or wrong. Tariffs and other trade measures could benefit the US economy if currently unemployed workers are pulled off their couches to make, say, solar panels or washing machines. There is almost certainly no benefit if the workers making solar panels would be pulled off current jobs as farmers, border guards or hospital workers.
China’s potential countermeasures run the risk of sending a cannonball through its own foot and that of others, especially if they roil global financial markets. China would be using a very broad weapon to attack a very narrow problem, so they want to calibrate how significant the collateral damage is.
If China did an assessment now of whether their implied threat to Treasuries had worked or not, they probably would not be sure of the answer. Most of the moves in bond yields and the dollar likely reflect global growth and inflation risk, and uncertainty about how tolerant the Fed would be of faster inflation under the new leadership of Jerome Powell. Still, that won’t stop China from using financial measures as a threat to mitigate US trade actions, but that’s not much of a threat at all.
— Bloomberg
Dr Steven Alfred Englander was the Managing Director, Global Head of G10 strategy, and Global Head of Currency Strategy at Citigroup Inc., Research Division