Tthe biggest area of focus for the Chinese economy at the moment is monitoring capital outflow and the impact on the Yuan. On the front, the changes in Chinese foreign exchange reserves is very important in tracking the ability to which Chinese policymakers can maintain a given level of the Yuan.
Since early January, China has introduced other measures to keep the Yuan steady other than using offsetting purchases by selling foreign FX reserves. One of those measure has been to increase borrowing rates in offshore Yuan. This peaked at almost 66% in mid-January and has come down to close to 7%, although this still well above a few months ago.
While some economists were quoted that "this rapid pace of depletion in recent months is simply unsustainable for any length of time," the fact that Chinese foreign exchange reserves stand at 3.3 trillion dollars suggest it can be sustained for some period of time. This level of reserves is much larger than prior to the crisis of 2008/09 when this was representative of the excess savings in emerging markets vs. the US.
One of the unspoken stories of this huge change in flows is the impact on other markets outside of foreign exchange and in particularly treasuries. Once upon a time, the threat of massive Chinese sales of US government treasuries was seen as a huge risk to bond markets. But this doesn't appear to have much discernible impact on bond markets at all, with yields still incredibly low.
Perhaps this issue will gain more prominence in the coming months,particular in the context of the term premium on US treasuries remaining so low. With, Fed policy rates rising and a large holder of US treasuries selling close to $300bn in the last 3 months, it is surprising that term premia have remained so low.
In fact, estimates of the term premia by the New York Fed are currently negative, suggesting that investors are paying for the risk that short-duration yields do not evolve as markets currently expect, rather than being compensated.
With the risks to the growth and inflation outlook in the US rising since the Fed raised rates in December, it is unlikely that rate hikes will go as the Fed has projected recently. The market has already taken a more dovish view on the path for the Fed Funds rate, but this is likely to be reassessed again as the FOMC projects more concern about the outlook for growth. This will probably be the larger determinant of the direction for bonds, but its worth keeping an eye on how the term premia change in light of other developments.
