Reports of China’s Economic Implosion Distract from Trouble in the U.S. Bond Market (August 26, 2023)

Reported weakness in China isn’t lifting Treasuries at a time when quantitative tightening is increasingly important 

By Lisa Beilfuss
August 26, 2023

Headlines across financial media lately have focused on an economic meltdown in China. But one of the most consequential developments for investors isn’t getting much airtime.

While it may be true that China faces serious problems connected to real-estate bubbles, heavy debt burdens and an aging population, the situation may not be as dire as portrayed. Instead, this narrative may be distracting from a related, but underappreciated, situation unfolding in the U.S. Treasury market.

Louis-Vincent Gave, CEO of Gavekal Research, lays out several reasons why he is skeptical that China’s economy is heading off a cliff. First, he says bank shares are a leading indicator of financial trouble and notes that Chinese bank stocks have been roughly flat this year. Second, Gave points to a lack of weakness in global commodity markets, which runs contrary to the China-is-failing narrative as China is a top importer of nearly every major commodity. 

Third, Gave says the share prices of luxury-goods makers such as LVMH, Hermès and Ferrari don’t reflect concern over a crash in Chinese consumption. And fourth, he notes that Chinese renminbi is grinding higher against the Japanese yen and is rebounding against the South Korean won. This latter point is at odds with what normally happens to the currency of a spiraling economy versus currencies of its immediate neighbors and competitors. 

Most importantly, reports that the world’s second-largest economy is imploding aren’t accompanying a surge in demand for U.S. Treasuries, the place where investors tend to seek shelter. Instead, the opposite is happening. 

“Here is the biggest market in the world, the bedrock of the global financial system, falling by close to double digits in a month. And perhaps most amazing, this meltdown is occurring on limited news,” Gave says. “This should be the news.” 

Gave has a theory about why the bond-market meltdown isn't grabbing headlines. “Is the Chinese news so bad precisely because U.S. Treasuries are melting down?” he asks, suggesting that muted flight to safety isn’t just a reason to doubt the China narrative but an explanation for it. As he sees it, narratives are created by established powers and handed to the media for public dissemination. Because most of the media would rather be wrong with the consensus than be right alone, the result is a press that latches on to a narrative and lays it on thick, Gave says. 

All of this matters not least because it is happening as quantitative tightening, the quiet side of this monetary tightening cycle, continues. 

QT hasn’t gotten nearly as much attention as rates in the media and on Wall Street, in part because it is harder to model, and because Fed officials themselves have acknowledged that they don’t know what they don’t know about the reversal of pandemic-era bond buying that doubled the Fed’s balance sheet to roughly 40% of GDP.

Since QT began in June 2022, the Fed’s balance sheet has shrunk by about $900 billion. While that is only a fraction of the roughly $4.5 trillion in pandemic quantitative easing, some strategists predicted QT would be over by now. The logic in part traces to the latest debt-ceiling standoff, which left the U.S. Treasury General Account–the federal government's operating account–uncomfortably low. Some worried the subsequent replenishment would drain bank reserves and disrupt markets, but the refill instead mostly came out of the Fed’s reverse repo facility, or RRP, where nonbanks and money market funds have parked trillions to obtain additional yield. 

Successful draining of the Fed’s RRP to refill the TGA enables ongoing QT, says Joseph Wang, chief investment officer at Monetary Macro and a former New York Fed trader. Wang says it is underappreciated by markets that QT will continue, at least for now. What is more, it is happening at a time when the Treasury is selling an increased amount of debt to help finance a surging budget deficit. QT plus more issuance means more supply needs to be absorbed by investors, translating to upward pressure on Treasury yields as prices fall.

This brings us back to the observations by Gave of Gavekal Research. “A Chinese meltdown, reminiscent of the 1997 Asian crisis, would be just what the doctor ordered for an ailing U.S. Treasury market: a global deflationary shock that would unleash a new surge of demand and a ‘safety bid’ for U.S. Treasuries,” Gave says. “For now, this is not materializing, hence the continued sell-off in U.S. Treasuries.”  

QT is crucial for multiple reasons. First, as Bob Elliott, chief investment officer of Unlimited Funds, says, the Fed needs to lower asset prices to slow income versus spending. QT is the lever to do that most effectively and with the least amount of pain and financial-stability risk, he says. The alternatives are an unpalatable amount of rate hikes, or a failure to achieve 2% annual inflation. 

There is another, more abstract reason why ongoing QT is important. Because QE has blurred the separation between monetary and fiscal policies, balance-sheet shrinkage is one way to reduce the risk of so-called fiscal dominance. 

Economist and Columbia Business School professor Charles Calomiris describes fiscal dominance as the possibility that government debt and deficits produce increases in inflation that overpower a central bank’s intentions to keep inflation low. The idea is that as fiscal dominance forces money supply growth, inflation rises and creates a new means of funding government spending–what  Calomiris calls inflation taxation.

It remains to be seen whether Gave is right about the economic reality in China.  Either way, investors should heed his warning that headlines about an imminent implosion there are overshadowing trouble in the U.S. Treasury market. The Fed’s attempt to unwind QE may worsen bond-market conditions to the detriment of such attempted tightening, meaning that inflation may be harder to contain than investors appreciate and that fiscal dominance is not so far fetched.