Asia | China | FX | Monetary Policy & Inflation | Rates
High frequency data on flows suggest inflows accelerated in November. Trade surplus for November was $75bn, a record high. Equity inflows were net +$8bn through Connect, and foreigners bought about $15bn in bonds – both above recent run-rates. My preferred high frequency BoP proxy shows the largest surplus in November since 2014 (Chart 1).
Nevertheless, RMB TWI stalled in November. While USD/CNY fell about 2% in November, PBoC’s CFETS NEER basket was flat. This combination of rising inflows and falling beta suggests domestic outflows or FX intervention picked up. Moreover, the sharp decline in FX forwards this week suggests that state banks are no longer sterilizing quasi-intervention USD purchases. This reduces carry on owning RMB.
PBoC is likely well aware that positive carry plus trend equals herd mentality. While they will permit some FX strength over time, I suspect they prefer two-way movement now. It is too early to speculate on the revival of outward tourism, but I suspect this may also play a role in balancing out the market next year.
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Summary
- Long Chinese fixed income FX unhedged is a multi-year macro trade.
- It’s underpinned by China’s favourable BoP position, high positive real rates, low foreign ownership, and the structural liberalization story.
- According to the Bloomberg/Barclays’ bond index, China fixed income returned about 8% since end-June, though this was almost entirely thanks to the currency.
- Bond yields rose on a combination of tight bank funding (CD rates), heavy supply and a hawkish shift in monetary policy stance.
Market Implications
- Medium term, positive FX and rates. Expect slower gains in the currency and slightly better performance in bonds over the next three-to-six months.
Currency to See Slower Gains
High frequency data on flows suggest inflows accelerated in November. Trade surplus for November was $75bn, a record high. Equity inflows were net +$8bn through Connect, and foreigners bought about $15bn in bonds – both above recent run-rates. My preferred high frequency BoP proxy shows the largest surplus in November since 2014 (Chart 1).
Nevertheless, RMB TWI stalled in November. While USD/CNY fell about 2% in November, PBoC’s CFETS NEER basket was flat. This combination of rising inflows and falling beta suggests domestic outflows or FX intervention picked up. Moreover, the sharp decline in FX forwards this week suggests that state banks are no longer sterilizing quasi-intervention USD purchases. This reduces carry on owning RMB.
PBoC is likely well aware that positive carry plus trend equals herd mentality. While they will permit some FX strength over time, I suspect they prefer two-way movement now. It is too early to speculate on the revival of outward tourism, but I suspect this may also play a role in balancing out the market next year.
Another factor to consider is the Biden administration’s approach towards China. The Phase 1 deal expires in February 2022, which means re-negotiation would probably begin mid-2021. The consensus view is that President-Elect Biden’s approach will be to empower the Treasury’s FX manipulation approach, rather than President Trump’s tariff/quota-based approach. Again, it is too soon to be sure. We just have to monitor.
In short, my message is simple. RMB appreciated about 9% vs USD in the last six months. It is unlikely to repeat such a performance. My base case would be about 3-5% over the next six months, possibly with a corrective sell-off into this year-end.
Fixed Income
On the fixed income side, yields are likely to move sideways or drift a little higher, in my view. The economy is in a self-sustaining recovery cycle, with latest data surprising to the upside. PBoC has shifted away from an easing bias and is hinting at tightening.
The Bull Case for Bonds
Policy tightening will be focused on lowering fiscal impulse and controlling macro leverage, rather than increasing policy interest rates. That is, slower total social financing growth and regulatory measures like a new D-SIB Framework will expand the list of systemically important banks.
The supply/demand balance should improve going forward. In 2020, net issuance of govt/quasi bonds was about CNY10tn. Smaller fiscal deficit should remove CNY0.5tn and no ‘special’ bond issuance another CNY1tn from the 2021 tally. Meanwhile slower lending by banks may improve the demand side of the equation. To be honest, though, it is hard to make this particular claim definitively as banks’ appetite for duration varies with market trend.
Carry/slope: thanks to the recent decline in FX swap points, foreigners can fund 5Y CDB bonds yielding 3.4% via 3m CNH FX swaps at ~2.5%. Carry provides ample cushion for investors here. That said, foreigners are still not the price-setting flow, so this wouldn’t change the trend in bond yields.
The Bear Case for Bonds
The distinction between price-based and quantity-based tightening could be a red herring. With the economy performing better than expected, if the overall stance has shifted, then market interest rates would trend higher even without a repo rate hike.
The tightness in bank funding is regulatory driven and is unlikely to change next year. In fact, against the context of bank CD rates at over 3%, the 1Y MLF at 2.95% is starting to look like a subsidy. If CD rates keep rising, then risk is of MLF being hiked at some stage.
While the PBoC balked at tightening inter-bank liquidity after credit bond defaults in November, this could be temporary. They may test the waters with tighter liquidity again in Q1, especially if trends in economic data remains favourable.
Source: Bloomberg
Source: Bloomberg
Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank
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