In an interesting observation made on Aug. 27 by analysts at Bank of America, Chinese dumping of dollar reserves (Treasuries) may create such an impact on the United States, that the Fed would have to throw away any thought of raising interest rates and instead look very hard at implementing a new round of quantitative easing just to soak up the estimated $1.1 trillion that will be dumped onto the markets. In fact, estimates of how much China may have to sell is so great, it is believed that China’s currency stabilization efforts would erase 60% of the gains created by the central bank under its last bond buying program of QE3.
Estimating the size of that trade should be a good indicator for just how expensive it will be – i.e. how much in Treasurys China will have to liquidate – to keep the yuan stable. The question, as BofAML puts it, is this: “can China afford the unwinding of carry trades?”
The first step is estimating the total size of the trade. Although estimates vary, BofAML puts the figure at between $1 trillion and $1.1 trillion. Here’s more:
As analyzed above, the size of RMB carry could be quite high and thus exert downward pressure on RMB. But the PBoC should have scope to defend its currency if necessary. The PBoC’s toolbox includes its $3.65tn FX reserves (at end-July), as well as measurements to tighten FX controls on individuals, corporate and banks, if necessary, including imposing stricter requirements on NOP, among others.
That said, we doubt if the PBoC will persistently intervene as rapid decline of FX reserves undermines market confidence anyway and imposes challenges to the PBoC. Alternatively, the PBoC could impose stricter FX controls but that would be considered as a backward move of capital account opening up. Nevertheless, we believe the PBoC intervention will still have spillover effects on the market.
Here’s the point: if China were to liquidate $1 trillion in reserves (i.e. USTs), it would effectively offset 60% of QE3.
Furthermore, based on Citi’s review of the academic literature which shows that for every $500 billion in EM reserves liquidated, the yield on the US 10Y rises 108bps, if the PBoC were to use its reserves to offset a hypothetical unwind of the entire RMB carry trade, it would put around 200 bps of upward pressure on 10Y yields. – Zerohedge
This alone is something the Fed is and has been deathly afraid of since day one of their historic easing and zirp policies… the market itself forcing interest rates higher with the central bank being unable to manage or contain it.
To counteract the consequences of rising interest rates that would come from that much bond dumping by China, the Fed would have to almost immediately implement QE4 just to soak up these bonds or risk an absolute seizure in their debt markets.
In a long enough timeline, when you play with matches you will always get burnt. And since the entire economy has been artificially propped up and managed by the Fed’s use of money printing and zero interest rates for so long, this ‘force majuere’ from China may be too much for the central bank to handle, and bring them to the brink of even having to use their nuclear option… that of hyperinflation.
Kenneth Schortgen Jr is a writer for Secretsofthefed.com, Examiner.com, Roguemoney.net, and To the Death Media, and hosts the popular web blog, The Daily Economist. Ken can also be heard Wednesday afternoons giving an weekly economic report on the Angel Clark radio show.