It is not easy to recall another week in which there were so many potential changes to the broad investment climate. The relatively light economic calendar in the week ahead may allow investors to continue to ruminate about some of those developments. Here we provide thumbnail assessments of the main drivers.
China
The PBOC modified the way the reference rate is set.Currencies are allowed to trade in a band around the reference rate. The US dollar trades in a two percent band, while other major currencies, such as the euro are allowed to trade in a wider band. China had previously introduced what it called a “counter-cyclical” component, which was a bit of a black box, and allowed Chinese officials a tool to exert greater discretionary influence over the currency.
This was particularly important when China was in a vicious cycle of currency depreciation and capital outflows. A combination of capital controls and the broadly weaker US dollar environment saw the yuan strengthen and reserves grow over the past year. Officials no longer need the “counter-cyclical” lever, so they jettisoned it. This is seen as a step to allowing market forces greater sway and neutralizes a criticism that had been levied. The apparent embrace of market forces seems opportunistic rather than ideological.
There was one newswire story claiming that people close to Chinese officials were advised to be cautious about adding more Treasuries to the country's reserves. It was like a child's party game of “telephone” where a message is whispered and by the time the last child hears it, the message is often nothing like the original. By the end of the day, there were reports saying that China was not going to buy any more US Treasuries.
The following day, the State Administration of Foreign Exchange (SAFE) suggested the original journalists had either were quoting the wrong people or was fake news.Some then began arguing that China was trapped into holding Treasuries, but this is to misunderstand. The decision of how many Treasuries it wants is a function of the level of reserves it wants. Given the relative size of different asset markets, once the decision is made to accumulate reserves, now in excess of $3.2 trillion, its choices are terribly constrained.
Roughly speaking, a little more than 60% of global reserves, including China's, are invested in US Treasuries. There may be room for a marginal shift into euros, which China appears to have below average exposure, but the cost is significantly lower yields and less liquidity. Moreover, European officials are buying all of the net new supply. Lastly, we note that the dollar bond market is huge, and in any event, bigger than China. We see little correlation between the month-to-month changes in China's Treasury holdings, reported by the US Treasury, and the change in US yields.
Japan
The Bank of Japan's extraordinary monetary policy has evolved under Governor Kuroda. The shift to yield curve targeting from an aggressive quantitative easing requires the purchase of few government bonds to achieve the goal. Consequently, the BOJ bought fewer bonds than the JPY80 trillion signaled. The BOJ does not know how much buying will be required, nor is it committed to replacing maturing issues like other central banks, including the Fed, ECB, and BOE. The BOJ balance sheet did shrink slightly in December.
It was a bit of a quirk. The BOJ it is not content with the progress on inflation. Officials have been explicit that they will continue to pursue an aggressive monetary policy to achieve the inflation target. While the BOJ slightly trimmed the amount of bonds with long maturities that it was buying, it has not changed the purchases of short- and medium-term securities, or the others assets that it buys, including ETFs, J-REITs, and bank loans.
