Treasury Market's China Tailwind Is Fading at the Wrong TimeBy and
U.S. issuance set to rise to finance Fed taper, budget gaps
Yet a stable yuan suggests China demand for Treasuries may ebb
China’s appetite for Treasuries may be about to ebb just as America needs its biggest foreign creditor to step up and help finance a growing budget deficit. U.S. borrowing costs could rise as a result.
In the view of Wells Fargo, this year’s resurgence in Chinese buying of Treasuries is likely to peter out as the yuan stabilizes after a steep gain in 2017. Most analysts see little change in the yuan through 2018, from its current level of around 6.62 per dollar. A steady exchange rate suggests limited pressure on Chinese authorities to increase their Treasury holdings as part of intervening in currency markets.
For the U.S., the specter of cooler Chinese demand comes at an inopportune time, with the Federal Reserve tapering its portfolio of Treasuries and Congress debating a tax-overhaul plan that could increase the federal deficit by $1 trillion over the next decade. The U.S. debt burden was already forecast to swell by $10 trillion in that period even before any tax changes.
“It puts Treasury in a tough spot,” said Thomas Simons, a senior economist at Jefferies LLC in New York. “We have two very big domestic forces putting pressure on the market, and at the same time, our biggest global subsidy is pulling back.”
China owns almost $1.2 trillion of U.S. government debt, more than double the level from a decade ago. The bulk of the buildup came as the Chinese boosted foreign-exchange reserves to help offset a strengthening yuan.
The U.S. could rely on that appetite as the Treasury market soared above $14 trillion this year, from less than $5 trillion in 2007.
Now, a worsening fiscal backdrop means U.S. debt sales are about to accelerate just as Chinese demand may wane. Wall Street bond dealers project net issuance will approach $1 trillion in fiscal 2019, almost doubling from last year.
Predicting Chinese demand for Treasuries starts at least in part with forecasting the outlook for the currency of the world’s second-largest economy. When the yuan appreciates sharply, Chinese authorities tend to sell it for the greenback to cap the gains, recycling those dollars into Treasuries. When the yuan tumbles, the central bank unloads U.S. debt as part of propping up its currency.
A year ago, the consensus was for the yuan to weaken to 7.1 per dollar in 2017. However, the yuan wound up rallying about 5 percent this year. That strength came as the dollar tumbled broadly and amid speculation Chinese policy makers would buoy the yuan in the run-up to a key Communist Party meeting in October.
China has added $122 billion of Treasuries in the first nine months of 2017. In 2016, conversely, China dumped about $188 billion as the yuan sank almost 7 percent amid capital flight.
With a U.S. tax overhaul looming and the Fed poised to hike rates, Chinese officials are coming up with plans to support the yuan if needed, including currency intervention.
The People’s Bank of China and the State Administration of Foreign Exchange, the arm of the central bank that manages the nation’s reserves, didn’t immediately respond to faxes seeking comments.
A spokesperson for the Treasury Department didn’t reply to a request for comment.
Wells Fargo forecasts that the yuan will strengthen to 6.50 per dollar in 12 months. That magnitude of appreciation suggests China’s Treasury purchases won’t be substantial enough to cap U.S. yields, according to the bank.
“Given that we’re only looking for modest strength, then that would likely also mean there will only be modest buying of Treasuries based on past behavior,” said Eric Viloria, an FX strategist at Wells Fargo.
Ten- and 30-year U.S. yields will rise by roughly 50 basis points in 2018, the bank’s economists forecast, partly due to China’s reduced demand. The median forecast in a Bloomberg survey is for 10-year yields to rise to 2.95 percent in a year, from 2.4 percent now.
That back-up in rates could eventually lure overseas investors back to Treasuries, according to Simons at Jefferies. And some analysts don’t expect Chinese buying to drop off at all. TD Securities expects a depreciating dollar and relatively attractive U.S. yields to buoy Chinese demand for Treasuries in 2018, leading them to add even more than in 2017.
For now, though, the exchange rate and Treasury holdings may have reached an equilibrium, said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group Ltd. in Singapore.
“They are close to where they would like the share in their reserves, so there will be less buying,” Goh said. “The Chinese authorities have largely refrained from foreign-exchange intervention this year, and I expect them to stay on the sidelines next year.”
— With assistance by Tian Chen, and Saleha Mohsin