China took the historic step last week of letting its currency, the Yuan, depreciate against the U.S. dollar by the greatest amount since 1994 by breaking the Yuan/Dollar peg. We have written many times over the past few quarters on the economic weakness in China and the monetary policy easing measures that have been put in place to support the economy. This easing measure, which will likely have a larger economic impact than any previous steps, was taken to shore up the flagging export sector by making the price of goods cheaper to foreigners.
By pegging the Yuan to the U.S. Dollar, China also pegged their monetary policy to that of the U.S. With the Fed hinting at tightening monetary policy (while the rest of the world is easing), the U.S. Dollar has strengthened considerably, with the Yuan rising in value right along with it. This has hurt Chinese exports to markets like Japan and Europe.
Yuan v. Japanese Yen
Chinese Exports to Japan (growth rate Year/Year)
Yuan v. Euro
Chinese Exports to Europe (growth rate Year/Year)
These steps are likely positive for the U.S. bond market for several reasons:
- China is a major buyer of commodities. With this news, investors, realizing just how troubled the Chinese economy is, are capitulating and selling commodities. Steep price declines are deflationary.
- Twenty percent of U.S. imports come from China. As mentioned above, these goods will now be cheaper in the U.S. This, too, is deflationary.
- China has faced capital outflows for much of the year. To meet these outflows, the Chinese government has had to sell their foreign currency reserves, which are mainly comprised of U.S. Treasurys. In fact, the 6-month run rate for Chinese Treasury purchases is $10B, the slowest pace since 2013. Should this policy move stem the tide of capital outflows, China’s demand for Treasurys could pick back up.
Sources: Bloomberg, JP Morgan, Lombard St. Research, U.S. Census Bureau