The Chinese authorities have managed to calm markets for now with accommodative moves to keep the Chinese currency and local interest rates stable, following their surprise currency devaluation on Aug. 11. But Invesco Fixed Income believes there is more turmoil than meets the eye beneath the relatively calm surface of the markets.
The unintended consequence of China’s foreign exchange regime shift to a dirty float from a peg is the heavy selling of US dollars to support the renminbi.1 Most evidence points to large, steady capital outflows from China since the currency regime change. This has forced the authorities to intervene in the currency market to prevent a weakening of the currency. The mechanical reality of this policy is that China needs to raise US dollars via US Treasury sales in roughly the same magnitude as their intervention activity. We believe the People’s Bank of China (PBoC) has been selling US Treasuries to support this intervention, and that this has been one of the drivers of US Treasury price action in recent days. US Treasuries over the course of the past few days have not rallied materially in the face of equity weakness and, in fact, have traded with a persistent higher yield bias. We attribute this to selling flows from China.
We see no immediate end to the capital flows out of China and anticipate that the Chinese authorities will continue to intervene in the near term to support their currency. This should keep upward pressure on bond yields in the near term.
We are watching China’s onshore lending markets and capital outflows carefully for any signs of stress resulting from the new currency regime and associated intervention. If capital outflows do not slow, there is a risk that the need to intervene and sell US Treasuries to fund the intervention will continue.
Monitoring our view
We will monitor key metrics around capital outflow and currency intervention on a continuous basis. We would expect US Treasury yields to be pressured upward until capital flows out of China and consequent currency intervention cease, or until more flexibility is allowed in the currency, which would also end the need for China’s aggressive currency intervention and sale of US Treasuries.
See more from Rob Waldner on China:
China moves to calm global markets
Chinese yuan depreciates further: What is the endgame?
Chinese yuan devaluation surprises markets
1 A dirty float is a floating exchange rate system in which a government or central bank occasionally intervenes to affect the value of its country’s currency in a managed fashion. A currency peg refers to the policy of tying one currency’s value to another currency.
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