Why Is China Buying Treasuries Again - And Will It Continue?

When China surprised the global economy by increasing interest rates last week, the markets took it to heart and a sell-off ensued (and the CBOE Volatility Index jumped 8%). And so did a rush to safe havens, namely the dollar.

And at the same time the Treasury Department confirmed that China has been a net buyer of U.S. government debt for two months as of August, after gradually paring holdings since late last year. And this news comes after the country cut its long-term Treasury holdings by $21.2 billion in June - the most on record. So what’s going on?

Obviously, China loosened the yuan peg to the dollar in June, which meant that since the Chinese government maintained that peg by selling its currency and buying dollars, they suddenly had less reason (or desire) for dollars to invest in Treasuries.

So why have they started buying in the months since? The reality is that while the currency peg was ‘loosened’, it has been tightly managed within a .5% daily trading band. And that means that the Chinese government has to continue to buy dollars, and in turn Treasuries, to keep the yuan where they want it.

And as long as the Chinese government continues this ‘managed float’ of the yuan, they will have a trade surplus with the U.S. And as long as they have a trade surplus, they will continue to purchase Treasury securities.

After this weekends’ meeting of the G-20, Treasury Secretary Timothy Geithner said that he expects the Chinese government to allow the yuan to strengthen because “they recognize it’s important to the world”.

Okay. Now back to reality. China will continue to control movements in the yuan, and they will continue to run a trade surplus due to their ‘unfair’ currency manipulation. If anything, the fact that the central bank raised interest rates gives the government even less incentive to allow the yuan to appreciate. More likely, the Chinese government will work even harder to make sure that the rate increase doesn’t strengthen the yuan. While the Chinese economy is largely closed, higher rates stand to attract foreign investors, which would put upward pressure on the yuan. And besides that, the rate increase will help tame growth…so why allow the currency to do the same thing?

As it is, the Chinese economy is taking a breather. GDP growth slowed to 9.6% in the third quarter this year. And industrial production slowed to 13.3% last month.

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Source: Trading Economics

But the one thing that is in question is whether China will maintain its position as the largest holder of U.S. government debt. Japan increased its Treasury holdings to a record $836.6 billion in August, not far behind China’s $868.4 billion.

The bottom line: A slowing of the Chinese economy translates to the same for the U.S. And that may present an opportunity for China to trim some of its U.S. government debt holdings as investors drive up prices in a rush to safety. But we shouldn’t expect to see a huge Treasury sell-off by China. To do so would be “self defeating and they well recognize that”, as Brookings Institution senior fellow Kenneth Lieberthal told Bloomberg.

China will maintain its position, but that doesn’t make Treasury debt a great option. In the current interest rate environment, I would avoid Treasury securities, particularly long-term. I prefer short to medium term, investment-grade corporate debt.

Disclosure: No positions