There have been speculative manias for as long as human beings have been allowed to speculate en masse. US Housing, Dot Com, the South East Asian Tigers, Japan, the South Sea Bubble, Dutch Tulip mania… the list stretches on through financial history.
What do all these episodes have in common? People. The objects of speculative mania have changed, the century in which they have taken place has changed, but people haven’t.
We have a strange, and quite dangerous, propensity to do what everyone else is doing, especially when it involves making a quick buck. Combine this with our general refusal to learn from history, or the wisdom of those who have been there before, and bubbles come to represent the heights of human absurdity and comedic irrationality.
For those riding the bubble rollercoaster, the ride is gloriously exhilarating on the way up, and multiples more terrifying on the way down. For those who have lived through it all before, they present a mixture of frustration and resignation in knowing how it all ends, but being unable to convince those caught up in the mania of the dangers – people tend to learn things the hard way after all.
BBT&T is a Collection that tries to highlight the absurdity of emotionally driven herd behavior, that in retrospect, never fails to elicit sighs of “What were we thinking?!?”. It is our attempt, in full knowledge of its ultimate futility, at showing that bubbles are not driven by an asset’s underlying value, but its perceived value; not by purported rationality, but pure emotion.
Focus on the people, not the assets!
The recent rally in interest rates has seen 30y mortgage rates in the US rise sharply to about 4%.
These levels were last seen in 2019, and have given rise to concern and commentary in some quarters that rising mortgage rates will cause home values to tumble.
Are these claims and concerns valid?
In order to answer that question, we first have to begin with why these folks are making such claims.
Their perspective is based on a nifty comparison – that real estate, specifically homes, are essentially the same as 30 year bonds. As all fixed income folks know, higher rates cause bond prices to fall.
By extension, higher rates mean lower home values; simple and elegant logic.
Unfortunately, it is also way too linear and reductive.
First of all, a parallel can be drawn between homes and 30y bonds. This is simply due to the fact that most American homeowners take out 30y mortgages to make their purchase.
However, this doesn’t mean that the prices of both must have the same relationship to interest rates. This is clearly illustrated in the chart below.
A quick glance at the chart will tell you that changes in 30y mortgage rates are far more volatile than US national home prices.
That is, rates change more frequently, and to a larger degree, probably because mortgage rates are tightly linked to US 30y Treasury Bond rates. Which is to be expected, since the market for 30y USTs is both more liquid and international than US real estate.
In the decade between 1993 – 2003, US national home prices rose steadily, even as 30y mortgage rates experienced some large and volatile swings.
Clearly the relationship between both asset classes isn’t as straightforward as “rates go up, house prices go down”.
This is further supported by the fact that during the Great Financial Crisis (GFC) in ‘08 both home prices and mortgage rates fell together.
If you stop to think about it, this makes perfect sense.
As the housing bubble burst, home prices crashed, leading many people to not want to purchase a new home. The lack of demand for new homes translated into a lack of demand for mortgages, hence lower rates.
If homes were really 30y bonds, the relationship between their prices and mortgage rates would never be un-inverse.
The key here being that demand for homes drives mortgage rates.
Now to the last highlighted region on the chart above, the years leading up to COVID.
Between 2014 and most of 2020, national home prices didn’t really change much (remember that it’s a chart of YoY changes, not index values). This after huge growth rates in the years after the GFC, a trend which ended in 2013.
During this period, the YoY change in 30y mortgage rates was volatile, but for the most part, trending higher. If the “homes are 30y bonds” logic held true, we would have seen a corresponding fall in the YoY change in national house prices.
But we don’t.
As mentioned above, growth rates for home prices were flat.
To be continued…
The Evergrande contagion continues to spread, and has now begun to affect the market’s perceptions of China’s largest property developer, Country Garden.
Should the company continue to struggle to raise financing, it could mark the point at which the contagion embarks on its next phase, and spreads more widely through the rest of the Chinese economy.
Here’s a look at how USD bonds of Chinese developers are performing.
As the chart above illustrates, they aren’t doing well at all, and have resumed their free fall after managing to rally in November. The asset class is now down slightly more than 40% over the last 6 months or so. (as measured by the ETF and ICE index it tracks)
Considering that the Evergrande contagion has now reached Country Garden, it would be safe to say that the entire real estate sector has been engulfed. Should these problems lead to large write downs in the values of assets held by local banks, the contagion has a real chance at morphing into a domestic financial crisis.
This in turn exposes the Chinese economy to a broader credit contraction while impairing its banks – a dangerous combination. Needless to say, the direct and second order consequences of both problems are much larger in breadth and scope than if the crisis were contained to real estate.
Of course, the Chinese government knows this, and has been taking steps to do just that.
Last year saw cuts in the reserve requirement ratio (RRR) and the RRR for foreign exchange. They acted again yesterday with a 10 basis point reduction in the medium term lending facility, and a 10 basis point reduction in the reverse repo facility.
The 10 point cut makes it cheaper for Chinese banks (those that have access to these facilities) to borrow bank reserves. While headlines in the media portray this as a “liquidity injection”, implying that more money is somehow being pushed into the economy, that’s not the case at all.
Increasing bank reserves only serves to ensure that banks have enough of them to settle their customers’ daily transfers. This is useful, and can help keep the system intact by preventing bank runs. That is, when customers rush to transfer or withdraw their funds en masse, leading to a bank not having enough bank reserves to fulfill its obligations.
While this is undoubtedly helpful, it does not actually increase the amount of money in the broader economy, simply because bank reserves do not get lent out.
The main way to increase the amount of money in the economy is for banks to make more loans, which Chinese banks are understandably cautious about doing given the current environment. Unfortunately, rate cuts and pumping the banking system with more bank reserves does little to remedy this.
Which makes it extremely important at this point to look for signs that the contagion is spreading to the banking sector.
Here’s how the broader Chinese fixed income market is doing.
As you can observe from the chart, prices have also fallen sharply since the turn of the year. Moreover, the largest holdings in this Chinese bond fund are long term debt issues of Chinese banks, which shows how unwilling investors are to hold on to them.
Clearly, Chinese banks are starting to feel the effects of the contagion, at least in terms of long term funding costs. However, this does not yet imply that a domestic financial crisis is around the corner.
For that to happen, we need to observe short term bank funding costs rise as well.
Fortunately, this has yet to happen.
The chart above, of a fund investing in 6 month to 3 year onshore debt of Chinese policy banks, is still steadily climbing higher.
Until prices of such instruments begin to fall, markets remain somewhat confident in the real estate mess resolving itself without unduly affecting the banking system. Or, they remain confident in the Chinese government’s ability to keep it contained.
Either way, keep an eye on Chinese short term rates.
Last but not least, here’s the CNY, which is still trading firm vs the USD, even after Evergrande’s formal default and rate cuts on multiple fronts.
Clearly Chinese banks and businesses are not struggling to get hold of Dollars. Which means that the Evergrande contagion remains contained within China for now, and has yet to spread to the global Dollar funding markets.
This is important as the international USD funding markets are the main conduit through which the Evergrande contagion can spread to financial markets across the globe.
However, this works both ways.
Should global Dollar liquidity deteriorate independent of China’s real estate crisis, it could exacerbate already worsening conditions in China, sparking a negative feedback loop.
In such a scenario, rising Dollar financing costs drive other, non real estate Chinese companies into default, which creates more domestic economic stress. This increases the likelihood of Chinese banks having to write down asset values on top of their struggling real estate linked ones.
More credit contraction follows, then more economic weakness, and even more write downs. The end result being a domestic banking crisis not directly caused by the Evergrande contagion, but certainly not helped by it.
Either way, USDCNY is a key variable in the ongoing saga. As long as economic conditions remain weak in China, the exchange rate must be closely monitored, regardless of Evergrande and Country Garden’s ultimate fate.
This scenario is the real threat to the Chinese (and global) economy, which makes it prudent to think of China hiking its FX RRR from the perspective of USD liquidity. In doing so, we can see that the hike has two main effects.
First, that the Chinese government is taking advantage of the large amounts of USDs flowing into the country through trade and financial investment (as CNY strength vs the USD attests) by putting some aside for future use. Put another way, the Chinese are ensuring that should global USD liquidity dry up in the future, they will at least be able to meet some of their needs by building a larger buffer of USDs now.
This is due to the RRR’s role as a buffer that helps to prevent bank runs. The hike mandates that banks have a larger amount of USDs on hand to meet daily net outward transfers of Dollars (if USD transfers net to an outflow). In other words, should liquidity in global Dollar markets dry up, causing Chinese banks to struggle to obtain them to fund their USD liabilities, they have a larger buffer to fall back on.
Second, the hike could also reduce the amount of USD denominated loans that domestic banks can make. This is simply due to them having to hold more Dollars in reserve, which means that they have to fund more of their USD lending via borrowing in the global FX or repo markets, instead of from their own USD balances. The result is less USD loan creation and a slower rate of growth in USD leverage within the Chinese economy.
Consequently, the FX RRR hike acts to reduce Chinese USD leverage and exposure while allowing them to save Dollars for the “rainy day” when global USD funding markets seize up.
Which begs the question, why are the Chinese building USD buffers and acting to reduce exposure in the middle of a widespread crisis in their real estate sector?
Are they taking steps in preparation for a “rainy day”, where Evergrande’s contagion negatively impacts Chinese corporations’ ability to tap global USD funding markets?
Whatever the case may be, context is important, and the context surrounding the FX RRR hike is gloomy, to say the least. Recently, we have had a broadly stronger USD, a RRR cut on CNY deposits, real estate developers defaulting every which way, and Chinese data which suggests a weakening economy.
All of this is, of course, connected. Some of these connections and resultant negative feedback loops can be traced back to Evergrande’s contagion, while others can’t. This is easily observed via the CNY continuing to remain strong against the USD, even though the Dollar is rallying against almost every other currency.
In other words, the Evergrande contagion is just one piece in the overall global economic puzzle, which by extension means that the Chinese government can only do so much to help keep the global economy afloat.
More importantly, if the Evergrande contagion does spread to the rest of the world via the Dollar funding markets, it would be doing so at a time where international financial conditions are starting to tighten, and economic conditions weaken. Which isn’t a good combination at all.
Maybe this is the scenario Chinese leaders were really preparing for when they chose to hike their RRR on FX deposits. If so, it would be wise for everyone else to start paying attention.
The apparent catalyst for last week’s plunge in the USDCNY rate was the Chinese government’s decision to increase the reserve requirement ratio (RRR) for domestic banks’ foreign exchange (FX) deposits. This effectively reduces the amount of USDs available in the Chinese economy, and was ostensibly done to halt the CNY’s continued strength vs the Dollar. Is this too simplistic?
What is curious though, is that this hike in the RRR for FX comes on the back of last Monday’s (6 Dec) announcement of an easing in the RRR for domestic bank reserves. In other words, less supply of FX, but more CNY liquidity within China.
Why would the Chinese government create scarcity for USDs just as global Dollar funding conditions are tightening (as demonstrated by the broadly stronger USD)?
Moreover, why do so when domestic companies are facing the prospect of being locked out of global Dollar funding markets due to uncertainty over Evergrande’s contagion?
The argument that the Chinese want to weaken the CNY only makes sense on the superficial level of wanting to boost exports. If you really think about it, a weaker CNY would do more harm than good, firstly by increasing debt servicing costs; and secondly by making it more expensive for Chinese companies to obtain the USDs they need to engage in international trade.
Ultimately, tighter Dollar conditions never bode well for economic growth, not just in China, but for the whole world. One only has to look at how sharply the USD rallies during times of crisis (e.g. 2008-2010 & 1Q 2020) to understand this.
Consequently, making the argument that the Chinese government wants to engineer a USD shortage in its own economy to weaken the CNY is the same as saying that the Chinese want to shoot themselves in the proverbial foot, twice.
While only the government officials who made the decision can tell us the truth of why they did it, it would be fair to think that they wouldn’t want to act against the best interests of their economy. And the best interests of their economy lie in continued access to Dollars at rates that are as low as possible.
In other words, they need to keep markets as calm about Evergrande and the wider property sector’s woes as possible – which they are, and have been, trying to do. The moment their narrative of “the risks can be effectively managed” fails, Dollar funding costs for Chinese companies will spike, and liquidity will dry up. More importantly, should this occur, the Chinese government will have to act to manage a disorderly rush by foreign investors and Chinese companies to obtain Dollars.
To be continued…
Evergrande has finally fallen into formal default, and is poised to undergo a major restructuring of its balance sheet. This hasn’t come as a surprise to anyone following the saga, as demonstrated by the Chinese fixed income market not plunging on the news, instead remaining close (and in some cases rallying slightly) to where they were trading in our previous update. What did plunge however, was the CNY, which isn’t a good sign for the rest of the world.
The CNY has rallied about 400 pips, from 6.34 – 6.38 (high to low), and mainstream media outlets have been quick to attribute this rally to the Chinese government’s decision to increase the reserve requirement ratio (RRR) for foreign exchange (FX) deposits.
While this would no doubt have played some role in the CNY’s move higher, it is important to remember that the USDCNY rate is managed by the People’s Bank of China (PBoC). More specifically, the rate is set daily by the PBoC, and only allowed to deviate 2% higher or lower. This is done to allow Chinese banks some leeway in obtaining the USDs they require from global Dollar funding markets, i.e. they can pay more for USDs if they need to.
Consequently, the PBoC’s market fixings are neither entirely policy driven nor arbitrary – they are based on the economy’s demand for USDs, relative to the FX market’s willingness to supply them.
From this perspective, CNYs’ sharp rally over the last two days could be indicative of a turning point in its recent strengthening versus the Dollar. Not just due to policymakers’ actions, but also to a growing demand for USD liquidity in the economy caused by Evergrande’s growing contagion (detailed here).
More importantly, the CNY has been, in recent months, the only major currency to strengthen against the USD. This means that USDCNY is rising in an environment where Dollar financing is already growing tighter. Should the fallout from Evergrande’s and the wider property sector’s default spread to the Chinese banking system and other parts of the Chinese economy, already fragile Dollar funding markets may freeze up entirely.
Watch what happens with the CNY very closely in the coming weeks.
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