Bond bulls should not rest easy. The world may have reconciled itself to the financial insanity of negative yields, as central banks continue to cut interest rates. But there are signs that the big rally in bond prices may be reaching a turning point. The reason? A major, long-term rebalancing in capital flows between the US and China.
Instead of excess global capital flowing into overinflated US dollar markets, money is moving into underinvested renminbi assets. China is turning from being one of the largest providers of global capital and a “double surplus” economy — having both a trade surplus and a financial one within its balance of payments — to a consumer of capital. This is a result of its fiscal deficit rising and current account surplus shrinking.
This trend could either significantly tighten global monetary conditions or, more unexpectedly, lead to the imposition of global capital controls. Both scenarios would shake bond markets out of their current complacency.
In the last year, after China opened up its capital market to foreign institutions and issued $1.5tn of government debt, foreign inflows into China’s bond markets shot up to $100bn, according to Wind data. Meanwhile, the country’s investment in US Treasuries switched from a positive annual average of $70bn to a negative $80bn.
China used to recycle its balance of payments surplus from trade and foreign direct investment into US dollar assets. Now that the surplus is in the form of inflows into domestic capital markets, this recycling is no longer required.
This rebalancing has been building over the past few years, effectively tightening US monetary policy further than just the Fed’s previous interest rate hikes. If the trend continues, higher US yields over the long-term are inevitable, as there is less money invested in dollar assets. This could translate into further shocks for emerging markets, as rising yields on the greenback suck money out of those markets, as well as leading to higher rates in Japan and the EU.
This would be a painful, but necessary, process. But there is a potentially more dangerous alternative for global markets, which would previously have been unthinkable in the US: capital market restrictions. Recent proposals from Washington to curb US investment in Chinese assets can be seen not just as a politically motivated threat in the context of the trade war, but as a way of preserving capital in the US dollar system and preventing it from flowing into renminbi assets. It is an economically logical, if not entirely rational, response to the capital rebalancing and the resulting economic hit.
This would be quite a reversal from recent decades. The US has benefited from three major waves of foreign inflows into US dollar assets in the past 20 years, starting with Japan in the 2000s, followed by China from 2008, and then the EU earlier this decade. The three major economies now hold about one quarter of US Treasuries, which supports the government’s record debt issuance and its low borrowing rates.
This capital account surplus has conventionally been attributed to trade inflows and prudent Japanese, Chinese and German households dutifully shovelling all their savings into the bank and not following the profligate spending patterns of the Americans. If that was the whole story, then it might be economically manageable.
But this understanding overlooks factors that effectively keep money trapped in each of these surplus economies. This has led to the creation of significant amounts of “excess” money, which is then lent out to the US through the purchase of dollar assets, whether the Americans want to borrow it or not.
China’s relatively closed capital account allows trade and investment flows into the system but not back out again. Japan, for its part, keeps excess money in its system through the yen “carry trade”, where foreign investors borrow in low-yielding yen to invest in higher-yielding assets overseas and then repatriate returns. This gives Japan an ongoing balance of payments surplus even though its trade surplus has disappeared.
The combined money supply of China and Japan is now $37tn, dwarfing the US at $15tn, despite their combined economies being smaller than America’s. The EU adds another $14tn, leaving the world with an excess of “low-velocity”, or inefficient, money that generates low returns.
The danger is the assumption that this is the new normal: a situation where excess money stays in the system, rates remain low, central banks continue to buy government debt and no rebalancing is required, as long as each country’s printing press stands ready for action.
But investors need to recognise that this situation is already changing. The shifting balance between the US and China threatens to undermine some of the cosy assumptions about how much excess capital the world can maintain, and whether this can also keep supporting the bond market.