What is happening in the bond market?
Treasury yields are reaching fresh cycle highs even with Fed hiking probabilities unchanged. Wonks are talking about r* again in a sure sign they have no idea what's happening. After all, if there's a higher neutral rate now, then it still begs the question: Why? It's certainly not AI and automation. Nothing has changed demographically.
What about higher debt? It's a problem and rising yields have followed the Moody's downgrade but I struggle to see anything else that's fundamentally changed. Could we have hit some sort of tipping point? Maybe but the timing of the turn in an economy that's nowhere near as indebted as Japan is hard for me to believe.
The obvious answer is China.
The market is having a major re-think on every assumption about China, starting with growth. In 2020, Chinese President Xi Jinping set a goal of doubling the economy by 2035. That's something that would require 5% annualized growth.
Covid happened so that target could be understandably delayed but we're now two thirds of the way through 2023 -- which should be a post-covid rebound year and Citi today lowered its China 2023 GDP forecast to 4.7% from 5.0%. That comes after 3.0% growth in 2022, 8.5% in 2021 and 2.2% in 2020.
In essence, China's growth prospects are being downgraded. The property bubble is bursting and policymakers are in any rush to fix it. Youth unemployment is high and officials aren't acting; instead they're no longer publishing youth unemployment data.
For a generation, you could depend on China stimulating hard whenever there was a slowdown -- growth targets were sacrosanct. We've been waiting for Beijing to deliver the bazooka but it hasn't come and it's now increasingly clear it won't be coming. A PBOC official called for consumer stimulus in a rare break with the party line but that thinking was quickly shot down.
The central bank still has room to cut rates but the puny 10 bps cut today in the 1-year LPR (and nothing in the 5-year) suggests -- again -- no urgency. And that's with China CPI running at 0% y/y.
The big stimulus program so far is aimed at manufacturers of automobiles and large appliances but markets are sniffing out a loser. We've waited for months for something bigger to drop but it's not happening.
Instead, real estate firms are going bankrupt and the losses are beginning to reverberate through the financial system. Everything in China is opaque and you assume that Chinese officials won't let it get out of hand but there's a chance of a US-style financial crisis stemming from real estate.
For the broader world economy, the worry isn't so much right now, it's the long term. Xi's latest published speech falls back on 'common prosperity' tropes:
“Some developing countries have almost reached the threshold of developed countries in their process of modernisation, but they have fallen into the middle-income trap and been stuck in stagnation for a long time or even backtracked substantially,” Xi said. “One of the reasons is that they have not resolved [social] polarization and stratification.
Xi also condemned Western modernisation, saying it maximised the interests of capitalists and was characterized by “wars, slavery, colonisation and exploitation."
None of these comments hint at a rush to boost growth or a rescue for property speculators.
So let's assume that China is headed for years of disappointing growth. What does it mean for global growth?
For one, Chinese investors appear to have figured it out. Chinese equities are flat this year and have been dead money for years despite some low multiples -- particularly in tech stocks.
The real problem is the currency. It hints at capital flight, which is exactly what you would expect in a slowing economy with leadership leaning hard into socialist talking points. The particular problem is that capital flight can lead to a falling currency, which leads to more capital flight.
Halting that vicious circle appears to be the preoccupation of Chinese policymakers at the moment. Recent fixings and orders to Chinese banks to intervene are sure signs that a fight is ongoing. Worries about a falling currency are also reverberating into rate-setting policy and may be why the PBOC has been so reluctant to cut aggressively.
So back to the bond market.
When banks need money to intervene in the currency market to prop up the yuan, where do they get it? First, they need US dollars. So where do they get them? They sell US Treasury holdings.
If they can halt the yuan's fall, there might be some temporary relief for bond sales but if we go back to the long-term view, this is turning into more of a structural problem. Repeated disappointment in China growth will lead to persistent pressure on the yuan, especially with US growth strengthening. That will result in more and more Chinese Treasury selling. It will also end the main reason for national FX reserve accumulation, which was an effort to stem yuan strength.
So markets are looking out into a world where the main sovereign buyer of Treasuries is tapped out. Moreover, the marginal buyer of commodities and a major driver of global growth may be on a different track. If that's the case, a big rethink is in order. The first thing market participants do in that situation is deleverage and evaluate. The evaluation is particularly hard in the case of China because for 40 years it's been a dependable source of growth.
What the world looks like with a struggling Chinese economy is hard to fathom but it might start with structurally higher Treasury yields in a reversal of the post-GFC norm. Or maybe other sovereign buyers step in as Treasuries offer substantial yields. For now, I share the growing concern about China and the path its economy is on, while waiting for headlines about stimulus or further real estate/financial sector problems.
Of course, there's also the chance Xi realizes that her must act or risk a step-down in growth.
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