China's Sale of Treasuries Signaled by Collapse of Swap SpreadBy
Record reserve drop in August reported by Chinese central bank
Dealer holdings of short-term Treasuries have been rising
The latest signal that China has been dumping Treasuries to support its currency can be found in the $380 billion market for interest-rate swaps.
Derivatives strategists are gleaning evidence of China’s sales from the shrinking gap between two-year swap rates and yields on similar-maturity Treasuries. Rates on swaps -- agreements allowing investors to exchange fixed interest payments for floating ones -- typically exceed note yields because their pricing is based on interbank rates, which have credit risk.
Yet that spread has narrowed since Aug. 11, when China shocked financial markets by devaluing the yuan. The gap collapsed this week to its narrowest since July 2014 as Treasury yields rose at a quicker pace than swap rates. Benchmark two-year yields reached 0.76 percent Wednesday, the highest since April 2011.
The slimmer difference is evidence of foreign central banks reducing Treasuries, according to William Marshall at Credit Suisse Group AG. About 56 percent of central banks’ holdings of notes were in maturities as long as three years as of June 2014, Credit Suisse wrote in a Sept. 2 note.
“We view the behavior in swap spreads as evidence that China and other emerging central banks are selling Treasuries,” said Marshall, an interest-rate strategist in New York at Credit Suisse, one of 22 primary dealers that trade with the Federal Reserve. “The two-year is the spot on the curve it should show up, as it is.”
China’s central bank has about a third of its $3.6 trillion of foreign reserves in Treasuries, making the country the largest overseas holder. The war chest sank by a record $93.9 billion in August as the People’s Bank of China sold dollars to bolster the yuan.
The decline in reserves may help balance the nation’s international payments and the currency hoard remains ample, China’s central bank said this week.
There are also signs that the Fed’s primary dealers are taking on the Treasuries cast off by central banks. The dealers’ holdings of Treasuries maturing in two years or less has soared in recent weeks.
For Dominic Konstam at Deutsche Bank AG, the movement is reminiscent of changes in dealer holdings in 2010 and 2011 when Japan bought dollars and sold yen, the opposite scenario from China’s recent operations.
In the case of Japan’s interventions, the currency maneuvers coincided with a decline in dealer positions in short-dated Treasuries, Konstam, an interest-rate strategist in New York, wrote in a note published Sept. 4.
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