US Dollar Shakes off Chinese Bond Scare as Strategists Say Threats to US Treasuries are “Questionable”

The UK's experience following then-Chancellor Gordon Brown's handling of Britain's gold reserves shows why China's veilled threat to US bond markets is questionable.

The US Dollar rose during early trading in London Thursday as traders shook off earlier concerns over a reported threat by Chinese officials to walk away from the US Treasury bond market.

A Bloomberg News report claimed Wednesday that officials in China had recommended to the Peoples Bank of China and other state authorities that they slow down the pace at which they buy US Treasury bonds, or halt buying them altogether.

The PBOC is the second largest holder of US Treasuries in the world, after the Federal Reserve, and is estimated to have some $1.2 trillion of the bonds inside of its foreign exchange reserves.

Its demand for foreign currency holdings has, over the years, been a key pillar of support for the US Dollar and made a big contribution to keeping US government borrowing costs as low as they have been.

The US 10 Year yield rose to 2.59% Wednesday in response to the news, which marks its highest level since March 2017, while the US Dollar index dropped around 0.50% in the morning part of the London session. The Dollar index was quoted 0.17% higher at 92.51 by noon Thursday.

Fears are that if China were to make one giant exit from the American bond market then it would result in a sharp fall in the Dollar and a steep rise in government borrowing costs.

Both of these things would be bad for the US economy and have consequences for global financial markets given the Dollar’s status as the global reserve currency and the US Treasury yield’s status as the risk-free-rate in chief.

“The authenticity of the report is somewhat questionable given the nature of such information getting into the public domain would not be in the interest of either SAFE, or the PBoC,” say Richard Grace and Elias Haddad, chief currency strategist and senior currency strategist respectively at Commonwealth Bank of Australia.

The strategists question the reliability of the report because, if China really were about to stop buying US Treasuries and decided to telegraph it beforehand, then it would hurt itself by driving down the value of the bonds already held on the PBOC’s balance sheet.

There is of course a historical precedent of such tactics backfiring on those who employ them.

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"Gold traders confirm that it was because the Government announced in advance that it was planning to sell such a large quantity of gold that the markets became depressed," The Telegraph reported then-shadow secretary to the Treasury Philip Hammond as saying in 2009. 

“The low price Gordon Brown got for selling our gold wasn't caused by bad luck. It was a staggering display of economic incompetence that has landed taxpayers with a £7 billion black hole.”

Between July 1999 and March 2002 the UK government sold 395 tonnes of gold at a series of auctions only before doing so, the Labour Party’s then-Chancellor Gordon Brown made details of the forthcoming sales public.

This has been credited with driving the gold price to decades long low before the auctions took place, and cheating the British taxpayer out of the full value of its gold holdings.

The Gordon Brown example highlights why Commonwealth Bank of Australia is saying Wednesday’s reports over China and its US Treasury holdings are unreliable.

It is possible that comments from the unnamed sources cited by Bloomberg and other outlets are connected to an ongoing trade dispute between the US and China.

A forthcoming decision from Washington over whether to impose sanctions against China for its trade practices and alleged failure to enforce international sanctions against North Korea may also have been at play.

“There is no evidence that China has been “slowing down or halting purchases of U.S. treasuries”. China’s rising foreign exchange reserves, and our view of USD depreciation, suggests China’s purchases of U.S. treasuries will either pick up, or more likely, remain stable,” say Grace and Haddad.

Of course, regardless of the eventual reason behind such a move, the idea that China's holdings of US bonds won't still shrink coud turn out to be wrong.

Not a Risk-free Proposition

There are many reasons why China’s holdings of US Treasuries might shrink in the years ahead, although none of these are connected to Wednesday’s reports.

“Central bank reported holdings of U.S. treasuries will generally register a decline when global foreign exchange reserves or the USD depreciates (chart 3). This positive relationship exists because many central banks intervene to slow the appreciation of their exchange rates when the USD depreciates,” Commonwealth’s strategists note.

A shrinking pile of overall foreign exchange reserves could mean lower demand for US bonds. So too could a long-established trend that has seen the world’s central banks seeking to diversify their foreign exchange reserves away from the US Dollar.

This has nothing to do with trade disputes and everything to do with the changing composition of the global economy, which has seen faster growing emerging markets like China laying claim to a larger slice of world GDP.

If central bank reserves are to be truly diversified, or bare any resemblance to the shape of the global economy, then reserves managers have to keep pace with this trend.

“To date, U.S. inflation pressures have remain muted. However, we believe U.S. inflation pressures are picking up. Consequently, some future selling of U.S. treasuries may be forthcoming by market participants, including from China, as well as elsewhere, because of inflation pressures,” say Grace and Haddad.

Inflation pressures have the capacity to prompt the Federal Reserve to drive the US base rate higher, which would mean market interest rates (bond yields) also have to move higher. That’s just how markets work.

In order for bond yields to move higher, bond prices would have to fall as the “coupon” interest payment is fixed at the point when new bonds are issued and cannot be changed to compensate for higher (better) base rates.

“We don’t see a material impact on the USD, and our view is for further USD depreciation as the global economy picks up and “other” central banks look toward tightening their monetary policies,” Grace and Haddad say.

“However, rising U.S. inflation suggests some upside risks to the USD are potentially building, emanating from inflation-driven higher U.S. yields, and larger than expected Fed rate hikes.”

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