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Trousers, the Chinese renminbi and Treasury prices
My wife wanted to watch ‘British Sewing Bee’ - a niche interest. Unusually, I wasn’t interested in hints on making trousers, so instead decided to mess about with hedging strategies for major assets. Through my idle experiments, I discovered that from 2015 till 2021 a portfolio for minimising tracking error of a Treasuries portfolio required large exposures to CNY and JPY, plus a bit of gold. I haven’t asked my wife, but I suspect it may not surprise her, because not much does. But it did surprise me.
Admittedly, my studies didn’t reveal a great hedge, but it was the best hedge within the sparse universe of assets I was playing with. What is remarkable is those relationships have persisted and the same weights have delivered significantly better tracking error since 2021 than in the period 2015-2021. What this means is that any move in longer-dated Treasury yields, up or down, has major consequences for Asian currencies, especially renminbi.
Obviously, the effect of yields on currencies isn’t exactly new, though it is usually short-dated rates which attract attention. One of the standout features of the ‘teens’ (2010-2020) in financial markets was that correlation between international bond markets became less important than correlation between bonds and currencies - with QE the link. Things got pretty spicy. There are stories (possibly apocryphal) of Mario Draghi plaintively asking Asian reserve managers NOT to buy the Euro assets as the single currency tried to address its sovereign debt crisis in late 2011. Eventually, ‘Super Mario’ found the best answer was simply to remove yield from Euro-sovereign bonds and so make them unattractive investments, with the added benefit that the Italian government was temporarily relieved of its fiscal concerns. The tactic took some time, but it worked eventually.
Then in August 2015 the Chinese renminbi devaluation sent a further reminder of the importance of currencies. The devaluation caused marked volatility in S&P500, NASDAQ, EuroStoxx, Treasury yield and shape of yield curve, VIX, corporate spreads (briefly) and gold (briefly). And in June 2016 the Brexit referendum result further buffeted global markets via currency disturbance.
Despite Brexit, the principal currency axis in the world remains the dollar/renminbi. And my trouser-making-avoidance-tactic reveals that currency behaviour, especially renminbi, continues to reflect US debt market dynamics. It’s ‘exorbitant privilege’ in action (the effect of Treasuries on currencies, not my trouser-avoidance).
Here are the hedge weights for a longer-dated Treasury basket for the period 2015 - 2021:
I won’t embarrass myself by showing you the tracking result. It is poor.
But now look at the out-of-sample tracking for longer-dated Treasury portfolio for the last two years using the same weights as for the 2015-2021 period.
That’s a pretty good hedge using only four currencies and a bit of gold. It is also much better than the same weights for 2015 - 2021. And updating the weights suggests further overweighting of renminbi and yen would improve the hedge. A short renminbi position on its own is almost as good.
I have not calculated the actual running costs of the hedge - which has to contend with the inverted curve of the US and the change in short-term rates. The recent PBoC reduction in seven-day reverse repurchase rate by 10 basis points to 1.9% lowers funding renminbi short positions. It is pretty clear the Chinese authorities don’t want to see the renminbi appreciate against the dollar. Does that imply they see returns from holding Treasuries improving? Or are they entirely focussed on domestic economic problems? Are they able to make a distinction?
All of which nicely reveals how Asian currency behaviour (and so policy) reflects Treasury market movement - as well as Fed policy more generally. Anyone can talk about a shift away from the dollar and announce grand plans to build a brave new financial future with stalwarts of financial probity like Russia, Brazil and South Africa. Unfortunately, until that brave future arrives it seems the fate of the Chinese currency (and policy) is to a great extent, determined by what happens in American ‘risk-free’ assets.