One question that’s probably worth asking on Wednesday is whether China will hike OMO rates tonight.
You’re reminded that the PBoC raised rates hours after the March Fed hike, marking a continuation of the effort to squeeze leverage out the country’s bloated shadow banking complex.
But even as the move was consistent with the effort to rein in speculation, hiking in tandem with the Fed also helps to stave off capital flight by ensuring rate differentials don’t compress enough to put downward pressure on the yuan.
Remember: China has enough fires to fight without having to worry about capital flight. That’s precisely why they added the comically opaque “counter-cyclical adjustment factor” to the yuan fix last month – so they could roll back exchange rate liberalization by exercising more discretion over the daily fix.
Indeed, it could very well be that the concerted effort to strengthen the yuan last month was partly attributable to a desire to frontrun the June Fed hike.
Because without the new fixing mechanism (which looks a lot like the fixing mechanism that existed prior to the August 2015 deval), the only way the PBoC could have kept a Fed hike from weighing on the yuan would have been to hike repo and MLF rates. But in doing so, Beijing would risk over-tightening, something more than a few analysts and commentators have warned about over the past couple of months as the consequences of tighter policy in China have become more clear (think metals mayhem, commodities carnage, and anomalous behavior in bond markets as shadow financing channels unwind).
So what did China do? Well, they went back to tightly controlling the daily fix, that way they could keep a lid on any yuan weakness that accompanied a Fed hike without having to hike themselves.
Here with more on this is Citi…
Will China follow the Fed?
This time may be different: Twice this year China has followed Fed rate hikes, by hiking OMO and MLF rates by 10bp in February and March. But we think there is a reasonable chance that the PBoC may leave rates untouched after tonight’s widely anticipated 25bp FOMC hike.
A few important changes have occurred since March: First, higher money rates have sufficiently widened effective rate differentials between China and the US. Second, capital outflows have eased in the aftermath of the change in the formula to determine the daily USDCNY midpoint. Third, China’s short-term money market rates are already quite high as banks are faced with a quarter-end MPA test. Given the PBoC’s stance of maintaining financial stability, it may choose not to follow the Fed hike to limit the pressure on the rates market.
That said, if the PBoC responds to a Fed hike with an increase in OMO or MLF rates, most likely it will be to reinforce its determination to contain capital outflows.
When will we know whether the PBoC has followed the Fed or not? And how? If China decides to follow a Fed rate hike immediately, it could do so via OMO rates like in March. On 16 Mar the PBoC announced an increase in OMO rates at ~9.53am local time. A change in MLF rates is unlikely in Jun. This is because last week’s RMB 498bn MLF already took care of Jun’s MLF maturity, and another MLF this month is thus unlikely. Any change in MLF rates is more likely in Jul, which would have the additional advantage that by then MPA tests and tight seasonal liquidity would have passed.
Potential market impact: On 3 Feb, immediately after the PBoC hiked 7d reverse repo rates by 10bp, the ND-IRS curve jumped by 20-30bp and CGB curve yield increased by 15bp, but both traded back in the next two weeks. Post the 16 Mar PBoC hike, reaction was milder. The ND-IRS curve jumped 20-25bp, while the CGB curve barely reacted. The ND-IRS curve also traded back in the following ten days.
If the PBoC follows the Fed again this time, we would again expect a mild reaction, given it would be much less of a surprise after the past two instances.