Earlier today, Bloomberg – citing the ubiquitous “people familiar with the matter” – confirmed what we’ve been pounding the table on for months; namely that China is liquidating its UST holdings.
As we outlined in July, from the first of the year through June, China looked to have sold somewhere around $107 billion worth of US paper. While that might have seemed like a breakneck pace back then, it was nothing compared to what would transpire in the last two weeks of August. Following the devaluation of the yuan, the PBoC found itself in the awkward position of having to intervene openly in the FX market, despite the fact that the new currency regime was supposed to represent a shift towards a more market-determined exchange rate. That intervention has come at a steep cost – around $106 billion according to Soc Gen. In other words, stabilizing the yuan in the wake of the devaluation has resulted in the sale of more than $100 billion in USTs from China’s FX reserves.
That dramatic drawdown has an equal and opposite effect on liquidity. That is, it serves to tighten money markets, thus working at cross purposes with policy rate cuts. The result: each FX intervention (i.e. each round of UST liquidation) must be offset with either an RRR cut, or with emergency liquidity injections via hundreds of billions in reverse repos and short- and medium-term lending ops.
It appears that all of the above is now better understood than it was a month ago, but what’s still not well understand is the impact this will have on the US economy and, by extension, on US monetary policy, and furthermore, there seems to be some confusion as to just how dramatic the Treasury liquidation might end up being. …