Although investors hang on every comment by Federal Reserve Chairwoman Janet Yellen to get insight on the direction of interest rates and what it means for the economy and asset prices, the real power to determine U.S. interest rates may be in the hands of China, according to Lombard Street Research. Facing an overvalued currency that is hurting corporate profits and slowing growth, China appears ready to dump its $1.3 trillion in U.S. Treasury bonds to drive U.S. interest rates up to strengthen the dollar.

The secret to China’s spectacular growth beginning in the early 1990s was devaluing its currency to the U.S. dollar from 2.8 Chinese yuan to 8.7 yuan. The devaluation cut the cost of Chinese labor by -68% and launched the cheap labor manufacturing boom. Exports as a percent of GDP grew from about 13% in 1994 to 39% of GDP in 2007.    

With the export boom causing huge labor demand, approximately 200 million rural Chinese moved to cities from to 2000 to 2007. During the period, China’s Shanghai Stock Index vaulted +330%, while the U.S. S&P Index was only up +11%.

But since 2006, the Federal Reserve and both the Bush and Obama Administrations have pursued weak dollar policies by pushing interest rates down. This caused the exchange rate of the dollar to weaken and the yuan to strengthen from 8.3 yuan to 6 yuan to the dollar. The +28% currency increase hammered Chinese competitiveness and exports fell from 39% to 26% of GDP of the Chinese economy.  

China tried to slow the fall of the dollar by increasing its holdings in U.S. Treasury bonds from $400 billion in 2007 to $1.33 trillion at the end of 2013. Despite spending almost a trillion dollars on U.S. Treasury purchases, the weak dollar policy caused the Shanghai Index to fall by -38%. But during the same period the U.S. S&P Index rose by +199%.   

As the overvalued yuan caused China export competitiveness to evaporate, China has tried to “rebalance its economy” to avoid massive unemployment by shifting to service industries. But “an expensive currency in a world of weak demand makes it impossible for China to rebalance its economy without a collapse,” according to Lombard. 

China’s $1.3 trillion of U.S. Treasury bonds sounds like 7% of the $17.7 trillion U.S. federal debt outstanding, but a third of the debt was supposedly “purchased” by the U.S. government to back Social Security and other purposes. Of the net U.S. public debt outstanding, China owns about 1 in every 7 dollars of U.S. Treasury Bonds. 

 “For a long time the threat that Beijing might sell US Treasuries rang hollow, but no longer” according to Lombard. “Growth trouble across the Pacific may have a much bigger impact on US yields in 2015 and 2016 than the expected pace of US central bank tightening” from the Federal Reserve.

The People’s Bank of China in November of 2013 announced they were ending their purchase of U.S. Treasury bonds. When China sold $48 billion in Treasuries in January, the yuan weakened by 5% to 6.3 yuan to the dollar. China has recently been intervening in the foreign exchange market to prevent the yuan from strengthening.

Although the International Monetary Fund estimates that the yuan is still 5-10% undervalued, Lombard believes that China’s currency is 15-25% overvalued to the U.S. dollar. The easiest way for China to solve the overvaluation problem would be to “liberalize capital flows” by removing restrictions that limit Chinese investments to bank savings accounts and real estate. But “if Beijing opened the flood gates, asset diversification would cause huge outflows that would swamp inflows.” Such action could trigger Chinese banking crisis.

A smooth sale of its U.S. Treasury bond portfolio by China would push up U.S. 10-year Treasury bond yields by up to ½% and U.S. interest rates by about 1%. The People’s Bank of China could intervene in the currency markets to smooth the yuan’s decline. This action “would slow but not derail the US recovery.”

But yuan devaluation and higher U.S. rates would be a lethal combination for the Eurozone competitiveness. Most European countries have modestly improved their trade positions with China thanks to softer consumer spending, which has capped imports. A much weaker yuan and higher U.S. interest rates would devastate peripheral European economies that compete with China for lower value-added manufacturing.    

The weakening of the U.S. dollar that began in 2007 may have precipitated the 2008 global financial crisis. China would prefer to not start another international currency crisis. But desperate to weaken the yuan to restart growth and support employment, Lombard Street Research believes China will soon start dumping U.S. Treasury bonds.       

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