Last week headlines informed us about China selling significant share of their American bonds. You can understand that as another episode of financial war between them. I think it is just a piece of a puzzle which will have dramatic impact on global markets and eventually will affect FED’s decision on whether to raise interest rates.

Since financial crisis broke out in 2008 central banks all over the world increased supply of money. Oversupply of free capital should officially stimulate the economy. In practice it was all about artificial demand for government debt. Printing machines started in the US but were quickly followed by Bank of England, Bank of Japan, People’s Bank of China and recently – European Central Bank.

It took seven years to increase supply of currency from 6 to 14 trillion USD.

Recently the PBC started to decrease supply of yuan ad sell currency reserves to stabilise its exchange rate. Those tactics are used not only by Chinese but other developing countries whose currencies lately lost too much. Cautious estimates say about 60-100 billion USD monthly. Others point out that China only sold over 150 billion USD… last month. China now has the first place in the amount American debt they own – worth 1,39 trillion USD. Combined worth of all Chinese currency reserves equals 3,69 trillion USD and in a year fell by 400 billion.

Gathering currency reserves by developing countries should have prevented déjà vu from the 1997 Asian crisis. Eighteen years ago so called ‘Asian tigers’ were developing in astonishing tempo. Their economic growth was truly a debt in dollars. When a slowdown came exchange rates decimated and lead tigers to serious recession. Difference between now and then is that central banks didn’t have big currency reserves that could be used to stop the panic by them intervening and selling the reserves.

Asian crisis was a lesson to be learnt. After 1997 many developing countries started a currency reserves (USD) build up. Peak of those was reached one year ago with 12 trillion USD. Since then numbers are diminishing systematically.

Importance of that lies in lower demand for the US bonds in which most of reserves are kept it. This puts a downward pressure on their price (yield increase). Academics estimate that with isolated market selling 200 billion USD worth of the US bonds increase their yield by 0,2-0,4% - and this is ONLY 200 billion. Nomura economists researched that the PBC sold US bonds worth 100 billion USD – both in July and August.

What are the consequences?

In 2014 currencies of many developing countries weakened against dollar pretty badly. In February this year this trend stopped. Last bubble burst in China scared markets again and fear scared capital away. To counter that central banks started to sell their dollar reserves (mostly held in us bonds) and limit the supply of their own currencies. Process called QT (Quantitative Tightening) is very dangerous for monetary system. Situation is so grievous that Japanese minister requested a extraordinary meeting of G20.

What we have here is capital flight from US bonds. To save their own currency, developing countries limit supply by selling their currency (dollar) reserves. We need to consider whether the FED will raise the temperature and make interest rates higher? OR will it do what no one dares to talk about – start another round of QE?

In my opinion increasing interest rates is unlikely. If FED be the first central bank to increase interest rates, even small 0,25 percent will give visible signal to the markets that it is the end of free-credit era. On one hand it could translate into strengthening of dollar but on the other hand, could spark hardly to control panic in financial world (and controlling this one is the key).

Starting another round of QE would generate artificial demand for bonds that could appease market and lift up stock exchange in the States. It is close to a 20% slump and this would be a symptom of a slump. Meanwhile, we await September and October – most chaotic months statistic tells.

 

Trader21