Moving in on her turf.

Photographer: SAUL LOEB/AFP/Getty Images

Janet Yellen Takes a Back Seat to China

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Traders have been panicking over the sudden rise in global bond yields triggered by the expected tapering of the Federal Reserve's stimulus programs. But an unlikely savior may emerge to limit the damage: China. That's the view of researchers at Oxford Economics, who think the world's second-largest economy is starting to eclipse the United States as the most influential player in setting global borrowing costs.

As the world's largest trading nation and holder of currency reserves, China has long held sway over economic activity in places ranging from Brazil to Indonesia. What's new is that the country's influence over global bond markets is beginning to eclipse that of the Federal Reserve. While traders still keep a close watch on decisions made by Fed Chair Janet Yellen in Washington, economic shifts in China are starting to matter even more for the global economy.

Oxford economist Adam Slater has run the numbers on three distinct growth scenarios for China: growth slowing in a controlled manner; a hard landing in which growth drops precipitously; and a sudden return toward growth in the 8 percent range.

The first is Oxford's baseline assumption, to which Slater assigns 55 percent odds. His models see growth easing to 6.6 percent this year and toward 5.3 percent by 2020. In this scenario, China's aging population, its slowing urbanization and President Xi Jinping's efforts to prioritize domestic consumption will all contribute to gradually slower growth. In that case, Slater says, China's slowdown won't necessarily "cause severe disruptions in global markets." Even if the Fed begins hiking rates in September, China's moderation will limit the fallout in bond markets. At most, Slater reckons U.S. 10-year yields would rise from 2.2 percent now to 2.9 percent by end of 2016.

Oxford estimates the second scenario -- a deep downturn in China -- is a 30 percent proposition and could leave U.S. 10-year rates at 1.7 percent by the end of next year. It assumes a "severe correction in the property sector combines with acute problems in parts of heavy industry leading to a serious bad loan problem in the banking sector," Slater says. "Both the supply of and demand for credit drop back, with the high leverage of many Chinese firms contributing to the latter effect."

The after effects would be broad and powerful, with Chinese property falling at least 10 percent and local government finances deteriorating even more dramatically. Next, foreign direct investment would plunge, the number of non-performing loans would skyrocket and stock markets from New York to Frankfurt to Singapore would slide. In that case, global GDP might average only 2.1 percent in both 2015 and 2016 instead of the currently expected 2.7 percent and 3 percent. That, in turn, would affect the calculations of central banks: the Fed would be less inclined to raise rates, the European Central Bank might keep rates at zero until perhaps 2020, and Japanese bond yields could remain at zero into 2017.

Surprisingly strong growth in China is scenario three. In that instance, China would fix its structural problems quickly and painlessly. "A stronger China," he says, "means strong world trade and GDP growth and faster rise in global bond yields." In the U.S., 10-year rates could rise toward 4.8 percent by 2020, while German bund rates might climb from their current 0.6 percent to 2.3 percent.

But there's a reason Oxford considers this the least likely scenario (Slater puts the odds at 15 percent). China's economy showed no signs of acceleration at the start of the second quarter: the most recent lending and investment data signaled the opposite. Fixed-asset investment, meanwhile, is the lowest in almost 15 years. Worse, China's default risks are soaring -- a side effect of a $20 trillion surge in credit since 2009 that's left many borrowers overextended.

Bond traders aren't the only ones keeping a closer eye on China's $9.2 trillion economy -- Yellen is, too. In February, she told Congress that for all the obsessing about Fed rates, foreign events "can pose risk to the U.S economic outlook." In China, she said, "economic growth could slow more than anticipated, as policy makers address financial vulnerabilities and manage the desired transition to less reliant on exports and investment as sources of growth."

If you sense a hint of anxiety in that quote, that's not an accident. Yellen is aware that she doesn't have nearly as much control over the fate of the U.S. economy -- and the fate of global bond markets -- as her reputation might suggest.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net