RegionsChinaFuture of US Interest Rates ‘May Lie in China’s Hands’

Future of US Interest Rates ‘May Lie in China’s Hands’

While investors fixate on every comment by Federal Reserve chairwoman Janet Yellen on the direction of US interest rates and what it means for the economy and asset prices, the real power in determining their future course may be in the hands of China according to Lombard Street Research.

In its latest analysis, the firm suggests that faced with an overvalued currency that is hurting corporate profits and slowing growth, China appears ready to dump its US$1.3 trillion in US Treasury bonds to drive US interest rates up to strengthen the dollar.

“For a long time the threat that Beijing might sell US Treasuries rang hollow, but no longer” according to Lombard. “Growth trouble across the Pacific may have a much bigger impact on US yields in 2015 and 2016 than the expected pace of US central bank tightening.”

The People’s Bank of China (PBOC) announced last November that it was ending its purchase of US Treasury bonds. When China sold US$48bn in Treasuries in January this year, the yuan (CNY) weakened by 5% to 6.3 to the US dollar (USD). China has recently been intervening in the foreign exchange (FX) market to prevent its currency from strengthening.

Although the International Monetary Fund (IMF) estimates that the CNY is still 5%-10% undervalued, Lombard believes that China’s currency is 15%-25% overvalued to the USD. The easiest way for China to solve the overvaluation problem would be to “liberalise capital flows” by removing restrictions that limit Chinese investments to bank savings accounts and real estate.

However, the firm notes that “if Beijing opened the flood gates, asset diversification would cause huge outflows that would swamp inflows.” Such action could trigger a Chinese banking crisis.

A smooth sale of its US Treasury bond portfolio by China would push up US 10-year Treasury bond yields by up to ½% and US interest rates by about 1%. The PBOC could intervene in the currency markets to smooth the CNY’s decline. This action “would slow but not derail the US recovery.”

Lombard notes that CNY devaluation and higher US rates would be a lethal combination for the eurozone’s competitiveness. Most European countries have modestly improved their trade positions with China thanks to softer consumer spending, which has capped imports. A much weaker CNY and higher US interest rates would devastate peripheral European economies that compete with China for lower value-added manufacturing.

The firm concludes that the weakening of the USD that began in 2007 may have precipitated the 2008 global financial crisis. China would prefer to not start another international currency crisis. Nonetheless, desperate to weaken the CNY to restart growth and support employment, Lombard believes China will soon ‘start dumping US Treasury bonds’.

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