A New Tale Resonates

Most traders apparently think
That Treasury prices will sink
If China stops buying
And so they are trying
Their profits, from this, to unlink

But strangely despite higher rates
The dollar, today, demonstrates
Low yields aren’t all
The buck needs to fall
Sometimes a new tale resonates

The biggest news overnight was the unsourced story out of Beijing that the Chinese had lost their appetite for US Treasuries. In fact, the rumor (or at least the concern) is that they may not simply stop buying them, but actively start to sell part of their holdings. This has been a key driver in the recent sharp rise in 10-year Treasury yields, which as I type are at new nine-month highs of 2.59%. (We need to go back to June 2014 for the last time yields were higher than this past March, and December of 2013, in the wake of the Taper Tantrum, for the last time they touched 3.0%.) Remember, the Chinese are the largest holder of US Treasuries which serve as the main vehicle to hold the bulk of their $3.1 Trillion of FX reserves. Last year, as the renminbi appreciated, their reserves continued to grow and alongside that, so did their demand for Treasuries. However, it is apparent they are no longer willing to tolerate further CNY strength, reducing the growth rate in their reserves, and correspondingly their demand for Treasuries. The multi-billion dollar question is, will they start to actively sell Treasuries, or simply stop buying them? A related question is will they seek to diversify their reserves away from dollars into other currencies?

It is the latter theory that seems to be driving the euro this morning, as despite the highest US yields in more than nine months, and the widest spreads between Bunds and Treasuries in nine years, the euro has rallied a solid 0.6% and is back above 1.20. The theory is that if the Chinese choose to diversify their reserves, they will be selling dollars and buying euros with the proceeds, thus driving the single currency higher. Also aiding the euro has been the non-stop rhetoric from the hawkish wing of the ECB, with Wiedmann et al hitting the tape regularly and discussing the end of QE while the doves remain silent. This has the market convinced that QE is ending in September with the most aggressive views calling for an early end. With regard to that thesis, tomorrow’s publication of the Minutes of the ECB’s December meeting might add some clarity. But in reality, we will need to hear more from Signor Draghi defending his view that QE is still necessary for the market to take heed. Ultimately, I continue to believe that the US inflation situation will play out more aggressively than that of Europe and that the Fed will continue to lead the way, dragging the dollar along for the ride. But that is not today’s theme!

But the G10 currency with the biggest move overnight was the yen, which has rallied a further 1.2% as I type. This seems to be a continuation from yesterday’s price action, which, if you recall, was driven by the news that the BOJ was going to be buying less JGB’s in their effort to control the yield curve. So now, in the course of just two days, the yen has rallied nearly 2%. This is proof positive that the central banks remain the key drivers of market activity. I would also argue that the combination of these two stories is a harbinger of what 2018 is going to look like, namely far more volatile markets than we experienced in 2017. As we continue to see the central banking community try to unwind their excessive extraordinary monetary policy experiments from the past eight years, the coma in which markets have found themselves is almost certainly going to end abruptly. And there is one other yen nugget to add, BOJ Governor Haruhiko Kuroda’s term is due to end in April. As of yet, PM Abe has not reappointed him, nor named a successor. This has led to concerns that a new BOJ Governor may have a different view of policy settings and therefore may adjust them more quickly than currently envisaged. That, too, would add to the volatility we are likely to see.

These stories have been enough to drive virtually the entire FX market with the result being the dollar is lower almost across the board. Of course, there is always an outlier, and today is no different. The ZAR continues to be the most volatile currency with a 1% decline after the ruling ANC declared that a discussion of removing President Zuma was NOT on their meeting agenda today. This implies that some decent portion of the rand’s recent strength has been due to a series of bets that they would get rid of Jacob Zuma, and more importantly, his destructive policy agenda. Meanwhile, TRY has also been under pressure seemingly on the back of position unwinding. In an example of a more classic market reaction, investors are responding to higher US yields by unwinding their carry trades in TRY and getting back into USD. If Treasury yields continue to rise, and I think they will, this trade has further to go, and will expand to numerous other EMG currencies. Remember, the carry trade is far more fraught when volatility increases, and that is something in which I have a great deal of confidence coming to pass. Hedgers, take note of the potential for higher volatility, it will have an impact!

There is no US data today, although tomorrow and, Friday especially, will bring us some important new information. In the meantime, we get three Fed speakers today, Evans, Kaplan and Bullard, all of whom hew closer to dovish than hawkish. So as I look ahead to today’s prospects, everything certainly points to further dollar weakness. This is supported by both the equity market weakness we are seeing overseas and in the US futures as well as the strength in commodities. Something that has not been getting much press, but which I think could be quite interesting, is that gold has rallied nearly 7% since the middle of December. The question here is whether this is a result of the broad based commodity rally, typically a harbinger of good economic times, or if this is a measure of fear increasing as it regains its status as a safe haven. I sense the latter may be closer to the truth. Look for more volatility, especially if we see Treasury yields pierce their March highs of 2.627%. That will open many more technical doors to further market shakeups.

Good luck