Firm China data boosts sentiment

It is turning into a solid start to the week for global equity markets and risk assets in general.  Growth concerns are easing and central banks globally have shelved plans to tighten policy.  Comments over the weekend that finance chiefs and central bank stand ready to “act promptly” to support growth, may also reassure markets. Meanwhile, it appears that the US and China are closing in on a trade deal, with US Treasury Secretary Mnuchin stating that enforcement mechanisms could work “in both directions”, potentially easing disagreement on of the contentious issues between the two countries.

In terms of data and events, US Q1 earnings, US March retail sales and industrial production, will be in focus this week alongside more Chinese growth data, elections in Indonesia and the second phase of elections in India.  In Europe, flash purchasing managers’ indices (PMI) for April will give some indication of whether there is any turnaround in growth prospects.  The news will not be particularly good on this front, but the surveys may at least show signs of stabilisation, albeit at weak levels.

China data at the end of last week was particularly supportive, with March aggregate financing, money supply and new yuan loans all beating expectations.  The data add to other evidence of a bounce back in activity in March, with the official manufacturing purchasing managers index (PMI) moving back into expansion territory.   The data comes off a low base after weakness in January and February, but suggests that Chinese monetary and fiscal stimulus is taking effect, with the economy steering towards a soft landing.

Chinese markets clearly like what they see, with equities maintain their strong year to date rally (The CSI Index is up over 34% year to date) and CNY remaining firm (CNY has been the strongest performing Asian currency versus USD so far this year) though China’s bond market will react less well to signs of growth stabilisation.  Chinese data this week including Q1 GDP, March retail sales and industrial production are set to add further evidence of growth stabilisation, helping to keep the positive market momentum alive.


Fed keeps the risk trade party going

Risk is back on and the liquidity taps are flowing. Fed Chairman Bernanke noted that it is “not obvious” that US asset prices are out of line with underlying values, comments that were echoed by Fed Vice Chairman Kohn, effectively giving the green light to a further run up in risk trades. The last thing the Fed wants to do is ruin a good party and the comments indicate that the surge in equities over recent months will not be hit by a reversal in monetary policy any time soon.  

Aside from comments by Fed officials risk appetite was also boosted by a stronger than forecast rise in US October retail sales, with US markets choosing to ignore the sharp downward revision to the previous month’s sales, the weaker than forecast ex-autos reading and a surprisingly large drop in the Empire manufacturing survey in November.

Fed comments were not just focussed on the economy and equity markets as Bernanke also tried to boost confidence in the beleaguered USD, highlighting that the Fed is “attentive” to developments in the currency.  He added that the Fed will help ensure that the USD is “strong and a source of global financial stability”.  The comments had a brief impact on the USD and may have given it some support but this is likely to prove short lived. 

The reality is that the Fed is probably quite comfortable with a weak USD given the positive impact on the economy and lack of associated inflation pressures and markets are unlikely to take the Fed’s USD comments too seriously unless there is a real threat of the US authorities doing something to arrest the decline in the USD, a threat which has an extremely low probability.

It is perhaps no coincidence that the Fed is attempting to talk up the USD at the same time that US President Obama meets with Chinese officials.  The comments pre-empt a likely push by China for the US not to implement policies that will undermine the value of the USD but comments by Obama appear to be fairly benign, with the President noting that the US welcomes China’s move to a “more market based currency over time”. The relatively soft tone of these comments will further dampen expectations of an imminent revaluation of the CNY.

Are foreign investors really turning away from US debt?

The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds.   A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.

Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar.  However, it is not easy for China or any other central bank to act on such concerns.  China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens.  Such a self defeating policy would clearly be unwelcome. 

One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve.  Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar.  The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.  

Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together.  Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years.  This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.

In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period.  This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid. 

Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months.  Fed custody holdings for foreign official investors have held up well.  In fact, these holdings have actually increased over recent weeks.  Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks.  Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric. 

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