Ad Hoc Commentary – as China stops buying accumulating USD reserves, USD will first strengthen before declining

“It’s no longer in China’s favor to accumulate foreign-exchange reserves,” Yi Gang, a deputy governor at the central bank, said in a speech organized by China Economists 50 Forum at Tsinghua University yesterday.”
“Less intervention and smaller gains in foreign-exchange reserves may damp China’s appetite for U.S. government debt.”
http://www.bloomberg.com/news/2013-11-20/pboc-says-no-longer-in-china-s-favor-to-boost-record-reserves.html

The impact of PBOC not buying UST will cause US interest rates to go up; while the impact of PBOC not accumulating USD will cause the US dollar to weaken. However, US interest rates going higher will have a second order impact that will cause US dollar to strengthen. Since the impact of US interest rates on US dollar is likely to be much bigger, we should expect the US dollar to strengthen for 2 to 3 years before it falls off the cliff.

We remember that the factory of the world, China, is an export powerhouse. And their companies had borrowed mostly in USD for the capital expenditure. It was a logical thing to do because:
1. US rates were lower than China rates
2. Their revenues are in US dollars
3. US dollar was expected to decline (they will likely find out in the next two years that this was one of their worst assumptions)
If it was just PBOC not buying US treasuries, then the US could probably still call on Japan and Saudi Arabia to help. However, Japan, despite being a staunch ally, is having problems on their own. Their famed 1 trillion dollar government pension investment fund (GPIF) is undergoing reforms. It looks likely the Japanese GPIF money is going into equities, and out of Japanese Government Bond (JGB). How they can continue to support the UST market to the detriment of their own JGB market when that happens is a question mark.

On Saudi Arabia, America managed to alienate them and Prince Bandar had threatened a strategic realignment in relationship. Some pundits focused on current income (i.e. US shale gas independence) and dismissed the threat. However, if we look at the balance sheet, this is a major petro-dollar nation and thus should not be taken lightly:

“…”The shift away from the US is a major one,” a Saudi source noted yesterday. “Saudi doesn’t want to find itself any longer in a situation where it is dependent.” He added: “All options are on the table now.” Prince Bandar is believed to have told western diplomats that the UN turnabout was meant to deliver a message first to the US…”
http://www.independent.co.uk/news/world/middle-east/ussaudi-rift-john-kerry-faces-a-headache-over-saudi-arabian-plans-to-shift-away-from-their-ally-over-syria-8897402.html

So, in all likelihood, US treasury yields will go much higher when China stops accumulating reserves. It is also likely that the Fed cannot taper. They don’t even need to if they are successful in breaking the zero bound on interest rates by introducing electronic money. When US treasury yields go higher, US interest rates will go higher. Loans that were taken out in US dollars will become prohibitively expensive. Chinese companies, which are already suffering from low foreign demand, will have to pay back their USD loans (i.e. sell CNY buy USD). Even those that have swapped their loans into floating rate USD Libor is going to suffer, not directly because USD Libor is likely going to be zero virtually forever, but indirectly because their bankers will ask for collateral on their underwater interest rate swaps.

And logically, since capital expenditures are usually an order of magnitude larger than revenues, the impact of USD loan payback will dominate over the next two years. This will give Janet Yellen the honeymoon in the first two years of her Fed presidency. And this will likely make it a very tough economic situation for Clinton come 2016. The elites are likely thinking very hard about the situation, and the next crisis is going to be extremely volatile. But, given the myopic nature of today, we should be celebrating S&P500 reaching 3000 before the next panic. Now that the stage had been set, the equity party should begin early next year.

Good luck in the markets.