ZeroHedge: something will break, but this time it won’t be China

By Eric Peters, CIO of One River Asset Management

from ZeroHedge:

“Market fears of rapid Fed tightening are occurring at a time when the central bank is still easing,” said Marcel Kasumovich, our Head of Research. “And the irony is not lost on the bond market. The rise in short-term rate expectations through next year is matched by the bond market’s conviction that policy rates will not get above 2% in this cycle. Something will break. But that something isn’t China or emerging markets thus far, as would normally be the case. The adage of the Fed sneezing and the world catching a cold may be fading in importance.”

“Nobody underestimates China’s strategic importance in geopolitics,” continued Marcel. “Many forget its cyclical relevance. In the past decade, China accounted for 44% of world GDP growth in US dollar terms. That’s ten points higher than the 34% for the United States and includes the 2016 period where China stagnated. The IMF’s best-guess is that China will contribute 25% to world GDP growth in the next five years, again higher than all other countries. When China says go, we all start to run.”

“The unimaginable is now a reality — China macro policies are leaning against the Fed. While the US is embarking on a hiking cycle, China’s monetary policy is easing and prudential policies are being relaxed to support property developers. The potential for developers to use escrowed deposits for bond repayments was welcome news last week — China’s senior real estate ETF, despite its very short duration, jumped nearly 20%. What is the root of China’s newfound policy decoupling? It is a gift bestowed by foreign investors.”

“Foreign buying of Chinese debt is not a new story. But it is one with lasting benefits. The world’s second-largest bond market enjoyed near-record inflows last November, the first month of China’s inclusion into the World Government Bond Index. And index accountants expect another 34% increase in net foreign buying of China in the coming three years. The mix of those inflows is two-thirds governments bonds, one-third bonds of ‘policy banks,’ the ones that run bailouts. Policy bank bonds are the off-index addition investors use to add a bit of yield as it is considered close to government debt.”

“China’s international policy was patiently manicured for more than a decade to achieve policy freedom. And officials are not shy about the benefits. Last December, a Director of China’s Ministry of Finance, Wang Xiaolong, signaled that the record rise in planned 2022 bond issuance was part of a pivot toward easing; he emphasized that the “expansion and contraction of treasury bond issuance reflects the direction of macro policies.” The direction of causality is also clear, obvious in market prices. In a sea of red, CNY and China large-cap financials are bright green, rallying. Foreign inflows are the source of China’s policy flexibility.”

“So robust is foreign demand for Chinese debt that local regulators are worried about instability,” explained Marcel. “Guo Shuqing, the architect of cleaning up shadow banking, warned of risks from foreign inflows last March. His caution on local property speculation was met with a prudential crackdown that did nothing to dampen foreign appetite for Chinese debt. Naturally, policy officials in the US and Europe failed to heed Shuqing’s warning of financial excesses. China listens to the Fed, not the other way around. Yet, unrelenting foreign inflows to a country that maintains an eternal option of keeping investor capital captive, shows just how different this cycle of Fed tightening will be.”

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