Well, here we are on Thursday and it feels a lot like Wednesday. Yields were up again overnight with the 10Y at 2.35 and while the dollar doesn’t have quite the same head of steam, the narrative here is clear: a hawkish Fed and progress on tax reform have ushered in a renaissance in the U.S. reflation trade.
Of course as we wrote on Wednesday evening, some of this is a game of catch up after the the dollar and Treasurys priced in gridlock in D.C., the escalation of tensions with Pyongyang, lackluster incoming data, and two devastating hurricanes to trade at YTD lows earlier this month. “The moves over the last three weeks are big, but can easily be dismissed as a reaction to the excessive gloom of late August (when the fed wasn’t going to hike again in 2017, Donald Trump’s war of words with Kim Jong-Un was beginning to make daily headlines, hurricane season was just beginning to affect economic sentiment and hopes of any fiscal easing had died),” SocGen’s Kit Juckes writes, in a great new note out this morning.
“But”, Juckes continues, “there’s the alternative theory, which is that this month’s moves originate in Beijing rather than Washington.” Remember, (or maybe “ren-member” is better – get it?), this month also saw a dramatic reversal in the yuan, which had spent virtually every waking second appreciating against the dollar since the late May/ early June short squeeze. There may be something to this. Read more from Juckes below…
Plotting 10year Notes against DXY provides the conventional view and the basis for what follows: The dollar turned higher as yields troughed, and once we’ve pried in a tax plan, a December rate hike, a couple more Fed hikes for 2018 and some political uncertainty in Europe, we can get back to our central scenario. But 8 September also saw the low in USD/CNH and USD/CNY. They have bounced because over the weekend of September 9/10, the Chinese authorities decided to scrap two measures aimed at supporting the Yuan when it was falling too fast (reserve requirements for institutions settling forward Yuan positions and foreign banks’ reserves against offshore Yuan deposits.
One school of thought is that the Chinese have played their cards exceptionally well this year in the FX market. At the beginning of the year, as President Trump made accusations of FX manipulation and unfair trade practices, it was clear that a further rise in the USD/CNY rate would be inflammatory. But the stronger euro, and the weaker dollar generally, came to Beijing’s rescue. That allowed USD/CNY to fall without the value of the Yuan overall going up.
At the same time, the weaker dollar stopped the fall in Chinese currency reserves. Official data show these recovering slightly. Data on their holdings of treasuries show a relatively bigger bounce. One interpretation is that China has been accumulating Treasuries to stop the Yuan appreciating too fast, buying Treasuries and driving yields lower than they would otherwise have been. Was that 2.03% 10year Note a function of expectations about the Fed, inflation and fiscal policy, or the result of Chinese buying in summer markets?
Lower US yields helped the dollar fall broadly, and so helped all the other currencies in China’s trade-weighted basket. A Machiavellian read would suggest that the Chinese were quietly buying EUR/USD to rebalance their reserves, preventing any correction and playing their part of the divergence of EUR/USD from relative yields, watching EUR/CNY reach levels not seen since 2014.
If Chinese reserve accumulation drove yields and the dollar down, supporting higher-yielding currencies in general, then September 8 marked a turning point. Policy was changed, signaling the end of Yuan appreciation, the end of the rally for Treasuries, high-yield currencies and the euro. When USD/CNY stops rising, buy EMFX and EUR/USD again?