Why China is more important than the Fed

20 мая 2015, 11:46

• China must sterilise $61bn per each 25bps RRR cut
• The lowest GDP growth in 24 years was just posted

• China may become the real catalyst for a low in US rates

As the US economy stutters towards reversal many minds are focused on the implications for the rest of us. But consider this: more often than not major economic shifts originate in Asia and that's why we should should be taking more notice of what's going on in China right now.
The so-called problem with China and its FX reserves is not what it might appear. This might have been the case considering China has moved from a 4.0% surplus in 2014 to a negative 1.0% now. However, some of this can be “extended” by a reserve requirement ratio cut which equates to a need to sterilise USD 61 billion per each 25 basis points cut in RRR. China Capital and Financial account surplus of GDP. Source: Bloomberg

Meanwhile, China's current account is improving slightly….China's current account as a % of GDP. Source: Bloomberg
M2 is the net beneficiary of the historic current account surplus.
M2 China, absolute and 12-month change
Source: Bloomberg

China just posted the lowest GDP in 24 years – but to estimate the impact of the RRR cut in USD and of course, the connection to selling zero coupon bonds globally, mainly US, check this:Source: Bloomberg

RRR is now 18.50% – the 20-yr average is 12.00%. However, assuming significantly more stimulus is needed to reignite China growth into "Silk Road" projections, we can conservatively estimate that RRR needs to go down. The BIS requirement is 4.5% and the US has operated with 6-8% since July 2013. In other words, the banking sector is allowed to leverage 22x outside US and 12.5% in the US – let’s assume China goes to the 12.00% 20-yr average.
The calculation then becomes:
(61 bln. US$ * ((20-12))*4 = 1.952 bln. USD. (61 bln. US$ per 25 bps, times 8% net change))

China FX reserves including “loss of RRR cuts”Source: Bloomberg

Finally, the “custody account” at the Federal Reserve, i.e: other central banks' holdings, remains as an aggregate largely unchanged since 2013, but Japan is now the biggest “shareholder” of US treasuries, replacing China:
Source: Federal Reserve
Combine this China “negative flow” with US monetary data:

Source: Federal Reserve

Clearly, the secular wind of the US bond market has changed – at face value China could become the real catalyst for a low point in US rates, even before the Federal Reserve proceeds with its expected “margin call”/normalisation rate hike later in 2015.
I have noticed in my excessively lengthy financial career that it's never in Washington (the Fed) where change begins. Often, it’s Asia. During my early days in the market it was Japan (the 1987 crash started in Tokyo) and now it 's China.
China “saved” the world through its gargantuan monetary stimulus in 2008/09. But this only bought time. China is now about to start the "Silk Road" initiative, but to “free up capital” for this it must reduce its close-to-zero earning stocks on t-bonds…
My take, however, remains the same: rates will creep higher for all of the above reasons, but… it will lead to a European recession and a US flirt with recession. This implies one more go at 1.5% in 10-year US yields as Fed will be too late in restarting the engines in 2016.
In short: I see 3.25% 10-year before year-end, then sub 1.5% on "recession light" in the US. I see gold at USD 1,425/50 per oz. as the rotation out of fixed income will benefit commodities at zero bound. Tangibles vs Intangibles, Inflation hedge vs Deflation.
I am still working hard on Steen’s Chronicle: Road Map to 2016 and Beyond, but wanted to share my China thoughts with you as it has material impact on the present rate view.

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