Last week US Vice-President Joe Biden met with Chinese Vice Premier Wang Yang to discuss trade and investment. As expected the Americans had a long list of demands: greater access to Chinese markets, Renminbi appreciation and a reduction in intellectual property theft. However in any negotiations and especially at the moment, the Chinese hold the upper hand because of their $1.2tn of US Treasurys.
The past six weeks have been terrible for the bond markets as the Fed talked of “tapering” QE. The ten-year yield to as high as 2.75% from 2.10%, and 10-year bond prices about 8% in just one month. Now 8% is not a large loss (especially compared to movements on the stock market) but it is the equivalent of three years of bond market returns given yields are so low.
The Fed’s tapering comment on May 22 and market reaction prompted both Carney at the Bank of England and Draghi at the ECB to warn against assuming the end of cheap money in the UK and the EZ as well. As the US economy is closer to “escape velocity” than either the UK or EZ, it is no surprise that the end of cheap money is coming to the US first. This monetary policy decoupling between the US and UK/EZ has been a dominant market trend since Draghi’s and Carney’s comments ten days ago. This is shown very clearly in the chart below – the difference between the ten year yield on German Bunds and US Treasurys. The American government now pays over 1% more than the German government to borrow for ten years. This is monetary policy decoupling in action.
The Bund-UST yield spread has risen to its highest level since the crisis began:
Although the markets have played out this monetary policy decoupling, the actual central banker’s rhetoric paints a much more confusing picture:
Markets still do not know how long Draghi’s “extended period of time” for low interest rates will last, presumably until economic data improves. But if that is the case, then it is not useful guidance as it is data dependent (and who knows when economic data will turn).
Carney’s warning on July 4 that “the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy” sent sterling dramatically lower. Markets had been anticipating a base rate rise almost by year end. However Carney’s power to control the MPC is still unknown. Although we will get a better guide when in August the Bank is expected to formally adopt more explicit forward guidance on interest rates.
And then the Federal Reserve is also contributing to the commotion. This week, Fed chairman Ben Bernanke followed Draghi and Carney’s warnings (of last week) with his statement that “a highly accommodative policy is needed for the foreseeable future” which sent the dollar lower (just like Carney’s comments sent sterling lower). The Fed’s attempts to differentiate between QE tapering (expected later this year) and tightening (probably not until 2015) is likely to continue to cause confusion.
While markets try to work out what exactly what central bankers mean with regard to rates, bonds and FX will remain volatile.
I would also be wary of tying myself too closely to the monetary policy decoupling trade. Why? Because once rate normalisation begins in the US, markets will conclude that it is only a matter of time before it begins in the UK and EZ too. Timing an exit will be difficult, mainly because the long bond trade (after a 30 year bull market) is exceedingly crowded. Many will want to sell bonds at the same time (and if bond funds see large redemptions, will be forced to sell) – a stampede for the exit. Pity the poor traders trying to execute all those sell orders with few buyers on the other side. AIG and Lehman reminded many of counter-party risk, the great rate normalisation may teach many the costs of liquidity risk (essentially that you cannot always get out of a position).
However this is a big advantage for the retail investor who doesn’t have multi-billion dollar positions (unless you’re Bill Gates). For most retail investors liquidity risk should not be a problem. Being more nimble should allow for greater flexibility to react to short term market moves.
Now returning to the top of this article, the Chinese situation throws a whole new spanner in the works. The UST market is worth around $12tn, so the Chinese hold a price moving amount.
According to the most recent data, the Chinese have actually been adding to their positions of USTs, holding $1.264tn in April of 2013, up a full £100bn over the last year. Although of course we do not have data for May and June when the bond market rout began. Japan is the next biggest foreign owner of US debt with a slightly smaller holding that the Chinese of about $1.1tn which has been relatively stable over the past year.
On top of all the central banker confusion, volatility and liquidity risk is added the threat from China. I would suggest that Joe Biden should have flattered the Chinese more. Thanks to their massive holding of US debt, they partially control the interest rate the US government pays on it. Large Chinese selling of USTs would cause yields to rise. US borrowing costs have already risen and many fear will rise further once QE tapers and the first rate rise becomes closer. In this environment, the US needs its Chinese savers.