Will China's falling forex reserves and selling of emerging markets cause U.S. stocks to fall?


This is a very long and circuitous thought process. When China’s foreign currency reserves fall, it is forced to sell assets in order to defend its currency peg to the USD. This selling of assets pushes foreign markets down.

History

China’s economy slowed down drastically in 2014 and 2015. As a result of this slow down, many Chinese businesses and millionaires/billionaires left for greener pastures elsewhere around the globe. Their selling of Yuan put upwards pressure on the USD/RMB currency pair.
Since China semi-pegs its currency to the USD, the Chinese government was forced to draw on its foreign currency reserves to stem this outflow and maintain the currency peg.
This is the part where many people get wrong. Most people think that the majority of China’s forex reserves are tied up in U.S. treasury bonds. This is simply not true. Only around 1/3 of China’s FX reserves are tied up in U.S. Treasuries. The rest are in global stocks, real estate, and other non-fixed income assets.
China’s forex reserves fell by approximately $1 trillion from 2014 to 2016. Of this amount:

  1. China only sold $200 billion worth of U.S. Treasury bonds.
  2. China mostly sold emerging market assets and stocks.

China’s massive selling of emerging market assets caused emerging market stocks to sink in 2015 (think Russia, Brazil). This bearish theme was connected to the S&P 500’s big correction from mid-2015 to early-2016.

The problem today

It seems as though China’s currency outflows have stabilized over the past few months. Hence, China’s forex reserves have also stabilized at around $3 trillion. As long as China controls its currency outflow problems, China does not need to sell its FX reserves.
But there are signs that China’s currency outflow problems may resume. Take these signs with a grain of salt. We are not worried yet, but are on alert.

  1. Bitcoin has been soaring over the past few weeks. It’s well known that Bitcoin is used by wealthy Chinese to smuggle their money out of China. The Chinese government only allows its citizen to take $50k USD out of China per person. So wealthy Chinese buy Bitcoin in China, then sell it for USD while they’re overseas.
  2. China’s economic data has slowed down a little bit over the past 2 months. Contrary to perma-bears like Zerohedge, the slowdown in China’s economy is not significant. It is well within the range of short term economic fluctuations that China has experienced over the past year. Perhaps this is just a temporary slowdown. But if this slow down continues, then China’s currency outflow problems will deteriorate and China will need to sell its FX reserves again.
  3. China’s stock market has been falling over the past month on its weak economic data.
  4. Europe’s economy is experiencing healthy growth right now. So the question is, why isn’t the Euro going up? The Euro has been flat over the past 2 weeks while European stock market indexes like DAX have surged. Remember that currency market players are a lot smarter than stock market players. Perhaps these currency players think that China will start to sell its non-Chinese shares again. If that happens, European and emerging markets are in trouble.

If China starts to sell emerging market assets again, then the whole “emerging markets will outperform the U.S. stock market” argument disappears.

Bottom line

If, for whatever reason, China’s outflows surge again and the Chinese government loses control of these outflows, the Chinese government will be forced to sell foreign bonds and emerging market stocks. This will directly cause:

  1. Foreign (non-Chinese) interest rates to rise. Perhaps this will push U.S. Treasury yields up?
  2. Emerging market stocks to fall.

Right now, the majority of investors are very bullish on emerging market stocks. Everyone recognizes that ex-U.S. stock markets are cheaper than the U.S. stock market, in terms of valuation.
People forget that the significant U.S. stock market correction of 2015 did not happen due to emerging market crashes. The Chinese stock market was almost done falling by the the time the S&P crashed in mid-August! (Our model predicted the significant correction of 2015 for other reasons).
However, falling emerging market is a bearish theme. History shows that a lot of small corrections are caused by technical reasons (i.e. short term mean reversion) combined with bearish themes.
So if emerging markets fall again, the S&P might make a small correction on this bearish theme.

*How this impacts the U.S. dollar and other currencies

These are just some thoughts.
China’s drawing down of its forex reserves does not directly cause the U.S. dollar to rise. Even if USD/RMB rises, that does not directly impact the U.S. dollar index. Yuan is not a part of the USD index.
When drawing down its forex reserves, China will need to sell emerging market and European assets in exchange for USD. The selling of European assets is bearish for the Euro. Since the Euro accounts for more than half of the U.S. dollar index, this is bullish for the USD.

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