(Originally published here.)
Could turmoil in Chinese financial markets be the cause of the rise in interest rates on U.S. Treasuries?
Danske Bank's chief emerging-markets analyst, Lars Christensen, explained the theory to me earlier today. Last week, China's central bank deliberately withdrew liquidity and pushed up the short-term interest rates banks pay to borrow from each other, in an effort to shove the Chinese banking system toward less risk-taking.
That squeeze, Christensen explained, caused Chinese banks to dump Treasuries onto the market. (China's central bank is famous for being the largest foreign holder of Treasuries, but its four largest banks appear to have big stakes, too, according to annual balance-sheet statements.) The influx of sellers then sent Treasury yields up. The U.S. 10-year note now yields 2.6 percent, up 45 basis points since June 1.
It's hard to disentangle the China crunch from changes in U.S. monetary policy, which is also moving towards tighter money. Christensen explains why China might be part of the story: First, the Federal Reserve didn't tell investors anything new last week. Second, interest rates have continued to rise well after the Fed's policy announcement last week.
I'm not much convinced by Christensen's argument. June 19 was the worst day for Treasuries this month, and the selloff happened within minutes of the Fed's 2 p.m. announcement. And I've made the case that the Fed did tell markets to distrust its commitment that it won't tighten if the economy remains weak.
There are three more problems. First, the capital flows we would expect to see if Chinese banks dumped Treasuries don't seem to have occurred. Second, the across-the-board rise in Eurodollar futures is consistent with faster rate hikes, not a Chinese panic. Third, past "flights-to-safety" have pushed Treasury yields down, not up.
To get liquidity by dumping Treasuries, Chinese banks would also need to sell dollars and buy yuan, pushing the value of the dollar down in terms of yuan. That hasn't happened. Instead, the value of the yuan has declined in recent days -- and that's remarkable because the Chinese central bank manages the yuan, aiming for a slow appreciation. The drop suggests capital outflow from China, not the expected inflow.
As I've pointed out in the past, futures markets are now anticipating much more aggressive rate hikes. That seems to be the explanation for rising bond yields. A selloff expected to be temporary wouldn't drive up long-term bond futures.
It also doesn't make sense that Chinese banks would sell Treasuries in a liquidity panic. In the fall of 2008, when investors rushed for cover, they bought up Treasuries, which markets considered a risk-free asset. They still do.
Is the Treasury market's meltdown a "China Syndrome?" Maybe. But there's a lot of evidence suggesting China's impact on Treasuries is as fictional as the 1979 thriller movie.