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Was Yuan devaluation an excuse for countries to protect their...

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    Was Yuan devaluation an excuse for countries to protect their capital outflows by dumping their US treasuries. Or is there another bonds root in US or the king USD is falling?


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    • MARKETSMARKET DATA[/paste:font]Expand
      • OPINION
      • Aug 31 2015 at 12:00 AM
      • Updated Aug 31 2015 at 12:00 AM
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      After tumbling below 2 per cent on Monday, bond yields then spiked, with US bonds suffering their biggest weekly price drop in two months. Reuters
      by Karen Maley
      After last week's violent gyrations, investors could be excused for hoping that global markets might settle down to a period of tranquillity. Unfortunately, that's not the signal emanating from the world's most liquid market – the multitrillion-dollar US bond market.

      Indeed, one of the most surprising aspects of last week's market turmoil was investors' marked refusal to treat US bonds as a "safe haven". Usually, a bout of sharemarket volatility causes investors seek refuge in bonds, which has the effect of pushing up bond prices and sending bond yields sharply lower.

      But last week a different pattern emerged. After tumbling below 2 per cent on Monday, bond yields then spiked, with US bonds suffering their biggest weekly price drop in two months.

      As a result, despite the huge volatility in global markets, the 10-year US bond yield finished the week at 2.2 per cent, a big increase from 2.05 per cent a week earlier.


      Some analysts believe that Chinese selling is responsible for the US bond market's aberrant behaviour. They argue that the Chinese authorities have been selling some of the country's massive $US3.5 trillion ($4.8 trillion) in foreign exchange reserves and using the proceeds to buy yuan in order to keep the currency from falling too sharply.

      In the past, when China was routinely running huge trade surpluses, the Chinese central bank kept a lid on the local currency by printing yuan and using the money to buy US dollars from Chinese exporters. These US dollars were then recycled into foreign assets.

      Although China does not disclose the composition of its foreign exchange reserves, it's estimated that around two-thirds of China's reserves are invested in US-denominated assets, mostly US bonds.

      But now the situation is reversed. The Chinese currency has been coming under pressure as more and more capital is flowing out of the country. In the past year alone, it's estimated that around $US500 billion flowed out of China.



      TOO DIFFICULT
      Because large capital outflows put downward pressure on the currency, Beijing has been forced to keep buying yuan to support its currency, which meant that it was eating into its foreign currency reserves.

      Eventually Beijing decided that it was too difficult – and expensive – trying to maintain the yuan's peg to the rising US dollar. Earlier this month, Beijing decided to relax its grip on the currency, allowing the yuan to devalue.

      But Beijing was fearful that its trading partners might decide to retaliate by pushing their currencies lower, which would set off a currency war. As a result, it has intervened heavily in foreign currency markets in the past fortnight, spending about $US150 billion to prop up the yuan. In order to buy yuan, Beijing has had to sell other assets, including US bonds.


      From the Chinese perspective, selling US bonds has been a positive, because it has cleared the way for the People's Bank of China to provide much needed monetary stimulus to the Chinese economy, without fearing too steep a drop in the currency.

      But Chinese selling represents a huge shift for the US bond market.

      After all, since the financial crisis, the US central bank has spent trillions of dollars buying bonds in an effort to boost economic activity by pushing long-term borrowing costs lower. The US central bank's third bond-buying program, known as "quantitative easing" or QE3, only ended last October.

      Some analysts warn that the pressure on US bond markets is likely to intensify as China tries to counteract the effect of heavier capital outflows. Analysts estimate US bond yields could rise by as much as 40 basis points if China sold $US200 billion worth of bonds.


      Even worse, many emerging countries are seeing their currencies come under pressure, in the wake of China's decision to devalue the yuan. As a result, they've been forced to sell foreign assets – including US bonds – in an effort to prop up their currencies and restore calm to markets.

      The risk is that this selling pressure pushes US bond yields sharply higher at a time when deflationary pressures are on the rise from the falling Chinese currency.

      Faced with a jump in real borrowing costs at a time when their profit margins are already coming under intense pressure, US firms are likely to shelve their hiring and capital spending plans, putting the US recovery in jeopardy.


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