Long term government bond yields have been transmitting a potentially recessionary signal that’s shaken investor confidence and reverberated across worldwide markets.
As investors fret over the weakening global economy, plunging bond yields may dissuade Beijing from potentially exercising what some fear could be a weapon in its trade dispute with the U.S.: Selling Treasuries (TNX).
The historic lows in long-term interest rates, and the resulting inversion of the yield curve, suggests that China would be fighting what’s currently the market’s most powerful trend. Massive selling would be met by investors’ bottomless demand for safety assets that can absorb the sudden Treasury supply.
In the Treasury’s latest International Capital (TIC) report last week, data showed that foreign flows into long-term U.S. assets were positive in June, with the bulk of the buying concentrated in longer-dated Treasuries.
Yet during the period, “China remained a net seller of U.S. Treasuries, but reduced the pace of its net outflows, while Japan remained the largest net buyer in the region,” Goldman Sachs economists said in a research note.
In fact, China’s diversifying out of dollars has been under way for some time, but picked up speed early last year. Those moves coincided with surging appetite for government debt that’s pushed down yields.
Goldman also noted that while Beijing remains the single biggest holder of long-term Treasuries, Japan’s total Treasury holdings jumped above China’s for the first time since May 2017.
According to most economists, the possibility that Beijing could offload its Treasuries en masse remains remote, even as tensions with its largest trading partner heat up.
Such a move would require Beijing to reinvest the proceeds, and it would also put upward pressure on China’s currency, the yuan (USDCNY=X). The country has recently allowed it to weaken modestly as it negotiates with the U.S.
“Moving the currency is a strong signal of the tone you want to maintain. In that sense, they have used currency as a signaling weapon,” Alessio de Longis, senior portfolio manager, global multi asset, Invesco, told Yahoo Finance recently.
That said, China offloading chunks of its Treasury holdings in a disruptive way is another matter altogether, de Longis said. Beijing would need to be re-invested the proceeds in alternative securities, and the yuan would probably shoot higher in the near term.
“Chinese [holdings of] Treasuries have been declining for many quarters” at a pace that’s considered “reasonable” and controlled, de Longis said.
“In an environment like this one where there’s insatiable appetite for [long-term] duration...selling Treasuries is not a good thing, and would do more damage than anything else,” he said. “It doesn’t make much economic sense to do it.”
Diversifying away from the U.S. dollar
At $15.6 trillion and rising, the Treasury market remains the world’s most liquid and deep market, giving global monetary officials a broad set of options to manage their currencies and amass reserves.
The U.S. dollar is still the reserve currency of choice: International Monetary Fund data shows the greenback comprises 61% of the world’s $11.5 trillion in FX reserves.
Still, the fear of China dumping Treasuries is palpable, given that Beijing currently sits on $3 trillion worth of foreign exchange reserves — the world’s largest cache, according to the IMF.
Of that sum, 58% are dollar denominated, statistics released last month by China’s foreign exchange regulator showed. Yet that figure is down sharply from 78% in 1995, underscoring how the world’s second-largest economy has been slowly but steadily diversifying its massive portfolio of foreign assets away from U.S. assets.
In recent months, as part of its broader effort to shift away from dollars, China’s been moving briskly to develop its own digital currency. The strategy is partly a response to Facebook’s (FB) potentially disruptive cryptocurrency project, Libra.
And anything is possible in a world where the globe’s two economic hegemons are slugging it out in a trade dispute that most top economists believed could be averted — until it escalated and hopes for an immediate resolution faded.
A South China Morning Post report in May, citing local reports, suggested that China might have “no choice but to sell” its Treasury holdings.
Nudging the yuan lower “send the message they want to send, that they’re going to retaliate by allowing the currency to weaken [and] soften the blow of higher tariffs,” said Kevin Daly, an investment manager of emerging market debt at AberdeenStandard Investments, which has $641 billion in assets under management.
Daly warned that a weaker yuan could trigger a round of competitive currency devaluations, as Asian countries try to make their goods more attractive in global markets. Yet he argued there was “no positive impact” from China selling off Treasury debt, which would likely see the yuan strengthen.
‘Graver than anyone seems to consider’
The idea of selling off FX reserves to counteract U.S. policy and domestic troubles has some precedent.
Russia has all but completely offloaded its own pile of US reserves, partly to help offset the bite of international sanctions. And when acute financial crises surface in emerging markets — such as Brazil in 1999 — governments often sacrifice large FX reserves that defend currency pegs.
Economists have long warned that China’s banking sector was a ticking time bomb, especially as the trade war heats up. As the Chinese economy slows sharply and its banking sector shows signs of strain, some observers think markets should be prepared for the unexpected.
“In this situation I believe the risk that Chinese policy makers lose control is very high indeed, not just in relation to the risk of capital flight such as we saw in 2016, but also the clear and present vulnerability of the banking sector that we have witnessed in recent weeks,” Albert Edwards of Societe General wrote in a sober research note recently.
“The market is currently almost solely focused on the Fed and the pressure the intensifying trade war puts it under to slash interest rates. And while the mainstream dismisses [President Donald Trump] as shooting himself in the foot by trying to face down a far more resilient opponent, maybe the situation in China is far graver than anyone seems to consider possible,” he added.
Javier David is an editor for Yahoo Finance. Follow Javier on Twitter: @TeflonGeek