Sunday, January 1, 2017

The Great Rotation

Since Donald Trump was elected president, US 10 year treasury bonds have sold-off drastically, pushing yields from 1.7-1.8% to currently 2.5-2.6%. Is this finally the start of “The Great Rotation” from bonds to equities? It almost feels like the boy who cried wolf here, given that people have been clamouring about the end of the bond market for, well, forever!

While I’ve certainly been on the bear camp for U.S. treasuries for far too long, the evidence here of an inflection point seems to be strong. And while many right now sing a song about how the market fears Trump’s fiscal policies will be inflationary, evidence seems to point another way for the true source of this inflection point: China.

From this USA Today article, Japan has overtaken China as the biggest owner of U.S. government bonds where at the end of October 2016 held $1.13 tn US government debt, above China’s $1.12 tn. China has been selling U.S. treasuries (on the record is ~1/3 of their $3.1 tn foreign FX reserves) in order to prevent a massive devaluation in their currency. Since October 2015, China has sold $139 bn of US government debt, or more than 10% of their holdings.

And the trend of China selling U.S. treasuries will undoubtedly continue. In the latest December Economic Work conference meeting, they emphasised the need to stabilise the Chinese Yuan (CNY). The most obvious method is liquidating their U.S. Treasury holdings and buying CNY.

But this trend in itself sets up a remarkable conundrum: as treasuries get sold, yields go up, the USD goes up, and the pressure increases for the CNY to depreciate even further. I can’t see how this doesn’t become an economic shock to the world, and potentially the start of the next crisis. If anyone can come up with an argument on how this gets resolved peacefully and without a crisis in China, I am sure the Chinese leaders would love to hear it.

The bond bears have growled and called wolf for many years (including myself!) and the evidence is increasingly compelling that they are going to see the big bad wolf show itself soon enough.