Central banks drive global hunt for yield

Article |
27 June 2017

Chinese foreign reserve management, due to its sheer size, has become a significant influence on global capital markets. In the decade to 2014, Chinese foreign reserves grew to the equivalent of approximately $US4 trillion. Capital flows are now a dominant economic driver for investors across the globe.

Between January 2015 and December 2016, China's foreign reserves fell by more than $US800 billion. This was because as Chinese growth slowed, capital deserted the country, compelling the Chinese monetary authorities to arrest the pace of outflows and currency depreciation.

Given the Chinese yuan was pegged against the US dollar this meant selling the US dollar to buy yuan. Much of these US dollar reserves were held in Treasury bonds. More than $US220 billion of US Treasuries were sold to facilitate this currency intervention; $US190 billion in the second half of 2016, with sales accelerating at year end when the US dollar strengthened swiftly.

This was in reaction to the Republicans gaining control of both houses of government' Over that period, US Treasuries climbed from 1.4 per cent to 2.6 per cent causing many to claim that not only was the 30-year bond bull market over, but it had been immediately replaced by a bona fide bear market This year, the US congressional fiscal policy stand-off has contributed to a steadily weakening US dollar. Coupled with Chinese capital controls and pegging die yuan to a basket of currencies rather than just the US dollar, the weaker greenback has re-established stability in local currencies.

Consistent trade surpluses and reduced need for central bank intervention is naturally replenishing foreign reserves and allowing central banks to once again accumulate US Treasuries. In fact, China bought $US38 billion of them in the first quarter of 2017. More recent increases in foreign reserves imply continued demand for US Treasuries, contributing to the fall in yield. That in turn has caused hedge funds and money managers to quit or pare back bets that bond yields would continue to climb. Ten-year US Treasuries have rallied, pulling their yield down to about 2.2 per cent.
There are limited options for foreign central banks to diversify their portfolios away from the US Treasury bond market but Australia is one of them. Sino-Australian trade flows underpin Australia as natural alternative. Central bank demand has contributed to the 0.6 percentage point fall in Australia's government bond yields since early March.

Australia's 10-year bond yields are about 2.4 per cent only 0.2 percentage points higher than comparable US bonds. This highlights the role central banks have had in driving the global hunt for yield. Trade surpluses in China and Japan are expected to endure for the foreseeable future.
Net asset purchases by major central banks will likely remain positive until late 2018. The European Central Bank is expected to reduce the size of its asset purchases, whilst the reduction of the Fed's balance sheet should match the asset purchases of the Bank of Japan. This means that Chinese capital flows will be a significant swing factor in determining the direction of global long-dated interest rates. China's current account surplus is inherently supportive of the purchase of foreign assets but its capital account is the swing factor and will be influenced by the path of US cash rates and dollar.

Higher US cash rates and a stronger US dollar draws capital away from China. Despite increased capital controls, capital outflows could be large enough to require the Chinese authorities to intervene, by again selling foreign currencies and assets.
The fast-moving and opaque nature of capital flows provide active fixed interest managers many opportunities to create significant value for investors.

These movements need to be monitored with a view to manage interest rate exposures to benefit from the cross currents of rising US Federal Reserve funds rates against the suppression of bond yields from Asian central bank reserve accumulation.

For more information Please contact

Bill Bovingdon

Bill Bovingdon

Altius Asset Management - Chief Investment Officer