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Mass Confusion: Fate Of US Treasurys Is Great Unknown Amid China Dumping

This morning, we got the official data out of the PBoC which shows that China liquidated around $94 billion in FX reserves during the month of August. Taking the FX valuation effect into account the actual drawdown was probably more along the lines of $115 billion. The numbers confirm what we tipped weeks ago - namely that the pace of China’s Treasury dumping increased dramatically in the wake of the August 11 devaluation. 

As we’ve been at pains to explain, China’s reserve drawdowns are simply the most dramatic example of a larger phenomenon that began with the death of the petrodollar. This phenomenon - the across-the-board liquidation of USD assets on the part of imperiled emerging economies - was characterized by Deutsche Bank as the end of the “Great Accumulation,” and as we noted earlier today, it has serious implications not only for investors’ collective perception of market stability, but for yields on core paper, for global liquidity, and for US monetary policy. 

The problem is that currently, no one is quite sure what those implications actually are. We know, for instance, that the massive liquidation of USTs will have a tightening effect on global liquidity. We began discussing this late last year in the context of the petrodollar, noting that for the first time in ages, exported petrodollar capital was set to turn negative in 2014 (i.e. a net draw on liquidity from petro states). Logically, this should put upward pressure on UST yields and will, all else equal, work at cross purposes with DM central bank QE. 

But all else is never really equal or, to put it differently, this isn’t happening in a vacuum and it could very well be that if China’s FX reserve liquidation serves to destabilize markets and trigger risk-off behavior, the resultant flight to safety could offset the EM USD asset sales. Of course it’s impossible to know exactly what precise mix of FX reserve liquidation and safe haven buying would net out and in the meantime, the markets for USTs, JGBs, and German bunds are prone to bouts of extreme volatility so don’t be surprised if the VaR shocks don’t return with a vengeance. 

To get an idea about the extent to which everyone is utterly confused, look no further than the following excerpts from SocGen (note the dates):

From Sunday, September 6:

Foreign official sector holdings of US Treasuries stand at just over $4tn, and the bulk is held by emerging central banks. All else being equal, any large scale FX intervention to defend depreciating national currencies should thus put upward pressure on Treasury yields, dismantling Bernanke’s “savings glut”. But all else is not equal. Current market tumult is more likely positive for “safe- haven” Treasuries. Moreover, additional QE from the ECB and BoJ are set to drag down on yields.  

From Monday, September 7: 

During the subprime crisis of 2008/2009 and the eurozone debt crisis in 2010/2011, investors sought a safe haven by investing in US treasuries or German bunds. During the first crisis, yields moved down by 170bp in the US and by 90bp in Germany. In the second, they moved down by roughly 110bp and 90bp respectively. But this is not what we have observed since mid- August as a result of China’s turmoil. Equity markets have plunged by 5% to 15%, but bonds haven’t reacted much. This highlights the fact that QE policy makes the usual safe havens such as bonds unattractive.

And if you think this is hard for the sellside, just imagine how confused a PhD central planner is...