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Risk of a sharp CNY rebound
Risk of a sharp CNY rebound
Summary
- Trending CNY weakness is not a surprise alongside a softer economic backdrop, central bank stimulus and portfolio outflows.
- Debt concerns are not a global systemic issue, as foreign debt accounts for only 6% of the overall total and has been on a declining trend as of late.
- CNY weakness and portfolio outflows are likely to reverse if Chinese equities are included in key global emerging market benchmarks.
Three benchmarks
The intention of the People’s Bank of China (PBOC), alongside further liberalisation of the currency, is to keep the valuation of the Renminbi ‘basically stable’ against a basket of global currencies. Risk of a sharp CNY rebound
Although the USD is the main currency that the market values the Chinese Renminbi (CNY) against, Chinese policymakers increasingly want to move the focus to a basket of currencies – the method they indicate they set the currency on a daily basis.
Officials state that the currency is allowed to deviate within a +/-2% band on a daily basis from the fixing rate which is partly determined by the closing value of the Renminbi on the prior trading day. Risk of a sharp CNY rebound
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In December 2015, the PBOC introduced the CFETS RMB Exchange Rate Index, to be more a representative valuation of the Chinese currency against its trading and investment partners. China Foreign Exchange Trade System (CFETS) is the foreign exchange markets subsidiary of the PBOC. There are 13 currencies in the CFETS basket, with the weightings largely trade based.
The other baskets that are referenced by Chinese officials are the IMF’s Special Drawing Rights (SDR) basket and the Bank of International Settlements (BIS) basket. The SDR is valued against the US Dollar, the Japanese Yen, the British Pound, the Euro and the Renminbi, while the BIS basket is valued against 40 different currencies. Regardless, the USD is the primary currency, with 26%, 42% and 18% weightings in the CFETS, SDR and BIS baskets respectively.
The recent onshore CNY weakness (against the USD) over the past two months doesn’t appear to be artificially distorted. Indeed, onshore traded Renminbi (CNY) moves in 2016 are in line with offshore traded Renminbi (CNH) movements. The gap between onshore and offshore markets that appeared during H2 2015 after the surprise CNY devaluation has all but disappeared, as the market becomes more comfortable with the more transparent CNY pricing.
No motivation for devaluation
If policymakers are devaluing the CNY the only motivation can be to boost trade. The benefits of currency weakness on trade is well documented. However, as the Chinese currency becomes more market-based, and most developed market central banks follow beggar-thy-neighbour stimulus to weaken local currencies, the gains to trade are likely be limited. Additionally with China sitting in the middle of many supply chains, the finished output to be exported could be more competitive as the currency depreciates. However, imported inputs to manufacturing would also be more expensive, limiting any strong benefits to devaluation from a trade perspective as well.
With so much focus and concern around China’s debt problems, the authorities are unlikely to want to exacerbate the problem by depreciating the currency, which would make the value of foreign debts larger in local currency terms. The fears are maybe overblown given that only 6% of China’s debts are denominated in foreign currency and are declining. However, given the nebulous benefits to trade from devaluation, increasing credit risks associated with devaluation (even though is small) does not appear worthwhile.
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There seems little motivation for policymakers to artificially weaken the Renminbi in the current environment.
Steady decline in FX reserves
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Currency weakness isn’t surprising for a country whose pace of growth is slowing, with a central bank in the process of cutting both the repo rate and the reserve requirement rate (RRR), and a government injecting other forms of stimulus. Calls for a stronger currency by foreign politicians are misplaced in such an environment.
Although the currency is officially managed against three benchmarks, the PBOC analyses its FX reserves in USD mainly. However, it has recently begun publishing foreign exchange reserves with the IMF’s SDR as the unit of account.
The PBOC is not actively devaluing the renminbi. Foreign exchange reserves are actually declining, a trend that could not occur if the PBOC were intervening in currency markets to devalue the local currency. Moreover, FX reserves have been in steady decline since mid 2014, after peaking at around US$4tn.
The recent weakness in the Renminbi has contributed to the trend decline in the outstanding level of foreign currency loans. If a loan is not hedged, a sustained decrease in the currency will lead to a greater debt burden. FX loans are likely to continue downward as the level of positive carry is expected to decline due to US rates increasing in coming years.
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June 14 deadline.
In addition to foreign debt, portfolio investment is critical to the direction of the CNY. Capital flows are likely to increasingly be a directional driver of the Chinese currency in the years ahead as liberalisation of the Renminbi gathers pace. Further currency weakness seems likely in the near term on this basis. Investment funds flowing out of China in Q1 2016, amounted to US$40.1bn, a 55% jump on a year earlier, according to the PBOC. In April, US$25bn of portfolio was withdrawn from Chinese assets, the 25th consecutive monthly outflows, according to the Institute of International Finance. Portfolio outflows can intensify as the decline in the CNY will have an adverse impact on foreign portfolio returns.
Nonetheless, the negative flows could abate quite quickly and even reverse in coming months. MSCI are expected to decide on June 14 whether to include Chinese A shares in its MSCI China Index (and consequently MSCI Emerging Markets Index). This is likely to prompt a lift of the CNY in the near-term as investment funds are redirected towards the country.
Liberalisation and beyond
Greater currency liberalisation is likely in the future, not only because of the greater scrutiny from the IMF (with the Renminbi now being in the SDR basket) but also as China seeks to gain greater interest in global commodity pricing dynamics. Currency transparency and flexibility are necessary to lure trading away from developed commodity trading platforms and encourage greater foreign participation on Chinese commodity exchanges. Although CNY weakness is warranted from an economic and portfolio flows perspective, the June 14 announcement of a potential inclusion of Chinese equities in key MSCI EM benchmarks could see recent CNY trends reversed. A greater degree of CNY volatility can also be expected alongside further liberalisation and transparency.
Important Information
General
This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”). The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities.
This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.
The iShares 20+ Year Treasury Bond ETF (TLT) holds US government bonds that mature in 20 years or more. Since peaking in March 2020 at $179.90 per share, TLT’s price is still down roughly 50%. Most of that drop happened as US inflation – and then interest rates – rose to multi-decade highs. But with inflation now below 3%, potential interest rate cuts ahead, and an interesting chart setup, the investment case for TLT could be building.
What is TLT?
The iShares 20+ Year Treasury Bond ETF (TLT) is an exchange-traded fund (ETF) that trades on the US stock market. The fund holds “long-dated” US government bonds with maturities of 20 years or more. By holding a basket of them, TLT reflects how investors generally value this part of the bond market.
Each bond in TLT is a 20-plus year loan to the US government. The investor lends money, and in return receives fixed interest payments (coupons) each year. The government sets the coupon rate when it issues (creates) a new bond, and that rate never changes. After issuance, the bond can trade on the bond market, where its price may move up or down.
What affects the value of long-dated US Treasury bonds (and TLT)?
All else being equal, long-dated Treasury bonds tend to be more volatile than shorter-dated ones. Interest rates and inflation expectations are the two main levers that can move their prices – and hence the price of TLT.
Interest rates: When rates rise, newly issued bonds pay higher coupons. Older bonds in TLT can then look relatively less attractive, so their prices may fall. When rates fall, it’s the opposite: new bonds pay lower coupons, so older bonds look “better” and may rise in price. Because TLT only holds long-dated bonds, its price tends to react more to interest rate changes than short-term bond funds. Rate shifts tend to have a bigger impact on long-dated bonds because their fixed coupons extend far into the future. Even a small change in yields can make those older coupons look much better – or much worse – for a very long time.
Inflation expectations: When investors expect higher inflation in the future, the fixed coupons (and principal) in TLT can look less valuable in today’s money. That perception can push bond prices down as investors sell bonds. And when investors think future inflation will be lower, the same coupons can look more valuable today, which may support bond prices. Because TLT’s bonds mature further into the future, inflation has more time to erode their interest and principal repayments. That’s why long-dated bonds are usually more sensitive to inflation than shorter-dated ones.
The chart below compares the price of TLT (orange) with US interest rates (black) and US inflation (blue). It’s not an exact science, but TLT has tended to move opposite to both of them since the ETF launched in 2003.
Other factors can also play a role. The US government regularly issues (creates) new bonds, and if supply goes up, prices can fall. On the demand side, big buyers like pension funds, insurance companies, or foreign central banks can move the market. Credit risk perception is also key. Investors usually see Treasuries as very low risk, but not “risk-free”. So if they lose confidence in the US government’s repayment ability, it could hurt bond prices.
The investment case for TLT today
We’ve explained how lower interest rates and lower inflation might be a better environment for long-dated US treasury bonds. As explained below, there are reasons to believe we could be moving into that environment now.
The US Federal Reserve (Fed) essentially has two jobs, and it’s a constant balancing act between the two:
- Keep inflation down (by raising interest rates to slow the economy).
- Keep employment high (by lowering interest rates to speed up the economy).
US inflation peaked above 9% in June 2022, and it’s been trending lower ever since. Inflation isn’t very low yet (2.9% CPI as of August) – but it’s low enough for the Fed to focus more on job number two. Factor in a slowing economy, and the Fed is more likely to cut interest rates from here to boost employment numbers.
The chart below shows the US unemployment rate in orange. It’s now at 4.3% (August) – the highest unemployment rate since November 2021. In the past, unemployment rose gradually at first, before eventually breaking much higher. If that pattern repeats, we could see a bigger spike in unemployment.
Not only is the unemployment rate rising, but the number of new job openings is dropping, too. US nonfarm payrolls (new jobs excluding farming, private households, non-profits, and the military) showed that the US economy added just 22,000 new jobs in August.
And to make matters worse, the government also revised its earlier estimates down. The adjustment meant the US added around 911,000 fewer jobs in the year through March 2025 than first reported.
AI could also factor into these numbers. After all, companies are rolling out AI tech to improve productivity – and that puts pressure on the “human” job market. AI can also make goods and services cheaper to produce, which is inherently disinflationary (the opposite of inflation).
This setup could give the Fed more ammo for bigger rate cuts in the future. Throw in lower inflation, and we could see a solid backdrop for TLT.
The technical picture for TLT
Not many assets are trading near 20-year lows. But as the chart below shows, TLT is trading near technical “support” from the early 2000s (orange). Also note that TLT recently broke above a downward sloping trendline that’s been in play since December 2021. This may signal that selling pressure is easing, and buyers are stepping in.
The chart below shows Bollinger Bands around TLT’s price. Here, the middle band is TLT’s 20-month average price, and each red or green candle represents one month of price movement for TLT.
The further the outer bands are from the middle band, the more volatile TLT’s price, according to the indicator. At this point, the Bollinger Bands are pinching together – a sign of relatively low volatility for TLT. Volatility tends to be “mean reverting” – meaning it usually cycles from periods of lower volatility to higher volatility. If the bands now start to widen, and the price trends higher, we could see a sustained rally for TLT.
The next chart zooms into the weekly timeframe, where each red or green candle represents one week of price movement for TLT. In this case, the Bollinger band width represents the volatility of TLT around its 20-week moving average. The blue line underneath it shows the width of the Bollinger Bands – lower is narrower, and less volatility.
Last month, the Bollinger Bands reached their narrowest level since September 2018. In other words, TLT’s volatility reached its lowest level in seven years, according to the indicator. Now notice how the bands started expanding this month – from that very low volatility base. This suggests TLT could see more volatility going into the end of 2025. Keep in mind that volatility is direction neutral.
Risks
The investment case for TLT depends heavily on inflation staying low and the Fed being willing to cut rates. If inflation rises again, TLT may fall further. Heavy government borrowing could also pressure Treasuries if investors demand more compensation to buy the debt. And if the economy holds up better than expected, the Fed might not need to cut rates.
How IncomeShares ties in
The IncomeShares 20+ Year Treasury Options ETP holds TLT and sells call options on it.
• Selling calls generates option premiums that aim to provide monthly income.
• Exposure to TLT keeps the ETP linked to bond price moves.
• If TLT rises too far, gains may be capped to the strike price.
• If TLT falls, the option income may help cushion part of the drop.
Key takeaways
• TLT holds US government bonds due in 20+ years, which are typically more sensitive to interest rates than short-term bonds.
• After years of losses, inflation is lower, yields are higher, and economic data points to a slowdown – but risks remain.
• The IncomeShares TLT Options ETP aims to generate monthly income by selling calls, while keeping some exposure to TLT.
Follow IncomeShares EU for more insights.
Your capital is at risk if you invest. You could lose all your investment. Please see the full risk warning here.
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