Submitted by Jeffrey Snider – Alhambra Investment Partners
Even a quick glance at recent t-bill rates commands further attention. There is obviously a lot going on in the bills market just in the past few months, which may only be unexpected in the sense that there isn’t a plain connection between US government bills and the fireworks elsewhere. T-bills used to be, however, the primary source of repo collateral and do function as an almost “risk-free” alternative to interbank cash holdings, so there are still tangible and direct connections to the outer “dollar” world.
While your attention is assuredly drawn to the prominent lump in the middle, the right hand “tail” is no less of significance particularly given a plausible (even likely) relationship between what appears to be opposite conditions. The first, occurring in the middle of August, is clearly China and its “dollar” run. We know that the PBOC and various other Chinese government (and government-connected) financial firms have been “selling” UST “reserves” though most commentary cannot grasp the full meaning and significance of why that would be. They talk about outflows and “hot money” without penetrating into the full extent of the wholesale “dollar” universe.
That is important not only because being comprehensive in analysis is necessary to understanding then and now, as there are innumerable subtleties that exist wholesale unexamined by “hot money” or bland, generic “outflow.” One of those is certainly a closer understanding of what exactly “selling UST” actually meant(s). It seems that mainstream commentary pictured bonds and notes being bid out in secondary markets but scant attention and appreciation has been paid to the bills market. Given the chart above, I think it more than reasonable that the steady climb in the bills yield (meaning, specifically, a larger discount to the price) traces to China’s attempts at managing the “dollar” run while maintaining the appearance of a steady yuan exchange.
The four-week bill hit 3 bps in translated yield on July 14 – not long after a highly unusual quarter-end where the bill rate was extended in negative yields (price premium). The max bill yield, both 3-month and 4-week, was, tellingly, August 10 and August 11. That would certainly correspond to the break in the yuan exchange rate relieving some of the “dollar” pressure the PBOC was attempting to fill via sales of its “dollar” holdings including bills – one more time, “dollar” run not “devaluation.” The escalation of intensity (and correlation to LIBOR, US$ GC repo, eurodollar futures, etc.) from PBOC activity could not be clearer in that regard, all the way to the breaking point in mid-August.
If the PBOC is rolling over perpetual bills alongside longer-dated maturities, it stands to reason that they would also manage their whole “dollar” reserves in a similar wholesale fashion. That would mean “reserve” mobilization would have been much more comprehensive and far deeper and multi-dimensional than simply “selling UST” of whatever class. In other words, if the PBOC was altering its bill strategy and engaging outright selling of UST securities, it was surely engaging repos and likely swaps of all flavors. After all, collateral in any of the derivative “reserve” activities is usually UST’s anyway.
It would also suggest transactions in forward contracts, a type of instrument the PBOC is intimately familiar with through its yuan management methodology. Thus, looking at the China’s “dollar” problem through the lens of wholesale finance opens up greater possibilities as far as what China has done (and is doing) about it.
In terms of swaps and forwards, those transactions will spread out the maturity of any liquidity element; which is a factor that the PBOC was certainly looking to accomplish though is fraught with less straightforward concerns. To take this route is to be almost desperate. This is where the PBOC might offer future delivery of “dollars” for local banks uncertain about current conditions (especially in mid and late August). Thus, local Chinese banks running a short “dollar” position would be better situated to hopefully outlast any near term disruption by trading overnight and ultra-short private eurodollar funding rollovers for a termed-out forward contract with the PBOC. The central bank pushes delivery into the future and with it the acute nature of illiquidity, but opens up risk transformations that are, again, far less observable and knowable.
This is pretty much standard central bank practice in any location under “dollar” duress; and it often leads to worse consequences down the road (Brazil works as a modified example). At some point, the central bank has to either deliver those “dollars” or continue the swap/forward rollover; the latter is a favorable option only for a short time. While forward transactions might be effective in “terming out” liquidity, they are inherently inefficient and costly (from the central bank perspective). If the goal is to calm the local “dollar” node of the eurodollar market, then moving the illiquidity a few months into the future (when crisis swaps and forwards start to mature) might actually make the situation worse.
That brings up an interesting potential connection with the PBOC “dollar” derivatives change from August 31. At that time it was rumored/announced that starting October 15 all Chinese banks (not their clients) would have to reserve 20% of nominal forex derivative positions for one year at zero interest. That would be the equivalent of banks delivering “dollars” starting October 15 to the PBOC for an interest-free yearly book; a quite convenient arrangement given the potential circumstances I have sketched out here.
But there is more to it than that, as this new forex reserve mandate is only one-way:
The sources said the PBOC will require banks trading currency forwards to set aside reserves from Oct. 15. Banks will be required to keep the equivalent of 20 percent of their clients’ forex forwards positions in dollar reserves to be held for a year at no interest, they added.
The base for calculating reserves will be the nominal value of new contracts clients sign with banks to purchase dollars, or banks’ dollar sales to clients, traders said.
Excluding clients’ dollar sales to banks gives a clear signal the move is aimed at curbing the yuan’s depreciation expectations in derivative markets, they said. [emphasis added]
In any situation where banks are funding “dollar” positions on a client’s behalf triggers this reserve; the transactions where the client is providing “dollars” to banks are not. Looking at that factor from the bland, orthodox perspective might lead to “curbing the yuan’s depreciation” as a reason for the peculiar arrangement here, while the wholesale view suggests a multi-layered tactic to suppress difficulties within China’s end of the global “dollar” short.
For one, it seems to have worked, at least for the month of September. While China still reported dollar outflows, -$43.26 billion, they were far less than anticipated and less than half of what was reported in the amazing “run” of August (-$93.9 billion). Predictably, that has led already to pronouncements that “it” is “over.”
As Cap Econ’s Evans-Pritchard says “Given we think the combined goods and services trade surplus will be roughly $20bn in September, this would put capital outflows at around $60bn, down from $90bn in August. ” Yes, there are questions about valuation effects and if policy banks were selling FX in the PBoC’s place (Evans-Pritchards says there is little evidence of that playing a major role) but the overall picture seems pretty clear. Pressure has subsided.
Which brings us all back to the question about what, exactly, is an “outflow.” If a flood of PBOC-generated swaps and forwards sets up only a maturity transformation moving the “dollar” pressure from August or September to October and November, then being effective means being able to either deliver “dollars” then (instead of September) without an October disruption, or going deeper into maturity transformations (a form of, as noted above, high cost future indebtedness) in order to continue fooling “markets” into thinking there is nothing going on at all by maintaining this same outward appearance of resumed stability. That latter is surely the motivation behind O/N SHIBOR’s sudden meaninglessness.
In my view, and this is speculative on my part but I don’t think unreasonably so, the October 15 reserve mandate seems to be a hedge on the PBOC’s “dollar” intentions as far as taking the first option so as to keep the process to as much of a minimum as possible. The second option, which is what Brazil opted for (as does every other central bank when forced by sustained “dollar” turmoil), is too asymmetric – you gain more maturity transformation, kicking the can further, but the cost to do so increases more geometrically than linear.
There is also a grand assumption at the basis of either option – that the “dollar” market as a whole no longer presents direct disorder! Buying time only works if the problem is one-off and temporary (dare I write “transitory”?). That brings up the eurodollar indications more recently, particularly after the September FOMC and then last week’s US payroll report. Worse, there seems to be a scramble for liquidity showing up in the t-bill market itself, which is the second part of unusualness I presented in the chart at the beginning. Negative t-bill rates, the 3-month most especially, represents only great stress. The number of times that those rates have been negative (bill prices at a premium) is inordinately few and particular:
Why were TARP and ZIRP unleashed in December 2008 (along with QE1)? Renewed funding difficulties more linked to pure dark leverage implosion and wholesale disruption that occurred even after the more apparent global asset markets crashed. September and December 2011, obviously, relate to the euro crisis which was as much a “dollar” and wholesale funding problem globally. And here we are again at the end of September and October 2015, wondering about different displays of “dollar” moves of foreign central banks, maneuvering behind the scenes in all sorts of exotic and peculiar arrangements; where t-bills are trading in the secondary market at negative yields (and the 3-month bill at auction went off at 0.00% for the first time ever recently), swap spreads are negative or sinking and the eurodollar curve is a shriveled, disjointed hump, unrecognizable to any process that suggests the “dollar” is sending warm and fuzzy vibes to all corners of Earth. And let’s not forget that global eurodollar banks are being awfully clear about their intentions in backstopping all of it; or, rather, to not.
I wrote back on September 1 about this PBOC forex reserve business that it might represent the contours of the central bank’s worst nightmare. The PBOC managed to get through September but only in these narrowest of terms; in other facets (offshore CNH funding, for instance) it wasn’t so nice and favorably projected. The more wholesale the a central bank goes, the worse it always seems to get down the road right where it is “supposed” to be the end of it.
There is another way to look at it, and this is really the nightmare scenario and not just for China but everywhere. By requiring private firms to deposit forex (mostly dollars) in October the PBOC might be planning for the worst case. It has, by now, appreciated just how limited actual mobilization of all those “reserves” actually can be, as even doing heavy intervention so far was largely ineffective despite all the convention about having all those protective reserves in the first place – the yuan still broke and China fell into the crosshairs of open disorder. And that is the larger point and confluence, where the PBOC “reserves” may contain further disruption if they aren’t properly calibrated (and they never are; again Brazil, Indonesia and the rest) just as the rest of the world wakes up to the fact that all those reserve piles were instead of being insurance against the worst case are the very problem itself – wholesale exposure as the decay in wholesale eurodollar reaches almost predetermined amplification. [emphasis in original]
Where are Chinese banks going to come up with that 20% reserve requirement in the first place? It’s much easier to just tune it all out and believe in central banks, that they have all this figured out and are not instead flying by the seat of their pants or just barely hanging on by a thread, undertaking measures that perhaps aren’t fully comprehended in all the angles and complexities. The PBOC, after all, is one of the “good” central banks believed far closer to omniscient than bungling. That is why it hasto be devaluation as the PBOC intended, since the wholesale realization is far less charitable for them and the rest of the world.
Even if you are predisposed to thinking more favorably about China’s central bank in all this, the PBOC issued a statement on September 8 about the forex reserve requirement that must be considered in this light. While the spokesman (this was supposedly a Q&A with media) describes almost perfectly the manifestation of the China’s “dollar” short and its recent “dollar” run (“pro-cyclical behavior” and “herding”) he imparts the official version of the central bank in blaming once again the awesome and fearsome power of “speculators” (Google translated):
Forward sales business is a bank, the company offers exchange rate hedging derivatives. Enterprises through forward exchange can circumvent some extent the future exchange rate risk, but due to the purchase of foreign companies are not immediate, and the corresponding need to purchase foreign exchange banks in the spot market, which will affect the spot rate, thus will affect far Behavior of the purchase of foreign exchange. This pro-cyclical behavior easily evolve into a “herding”, the impact of the market order. August 2015 sale of foreign exchange banks on long-term contract amounted to approximately January-July average of 3 times, indicating which speculative trading. With two-way floating RMB exchange rate increased flexibility, more concentrated possible future losses or business positions of default, increasing credit risk and operational risk of banks. Therefore, the bank forward sale of foreign exchange business into macro-prudential policy framework conducive to curb excessive volatility in the foreign exchange market, to prevent macro-financial risks and promote sound management of financial institutions. [emphasis added]
Nothing sounds so much like a central bank with its act together like damning those unspecifiable and apparently ubiquitous (in crisis) speculators.