Cause and Effect: China and the Fed face off

The combination of China's need to ease monetary policy and the Fed's desire to hike rates represents the single greatest source of volatility in financial markets for the rest of the year. Notwithstanding repeated liquidity injections and reserve requirement cuts, analysis suggests that there has been no net easing of monetary policy in China so far, given the size of the FX interventions.

Lost in the headlines is the link between China's actions and the US markets. The inability of Treasury yields to decline despite a sizable risk-off shock is likely linked to the sales of Treasury securities by the PBOC. Evidence from price action in the rates market (swap spreads, off the runs, 20y cheapening) suggest significant sales by reserve managers. The weakened negative correlation between US stocks and the long end of US Treasuries triggered by these sales likely created a VAR shock that forced general risk reduction, especially among the likes of risk parity funds.

Given the broad consequences of the Chinese intervention, the most important question remains how much capital can exit from China? A reversal of the QE era flows into China (since 2010) would suggest another $400bn could leave, while a reversal since 2008 would amount to a $700bn outflow. While the $3.6tn war chest is large, a continued burn rate of $200bn/quarter could be a threat to global markets.

"The impossible trinity tells us that there are only three possible outcomes from the Chinese situation. We believe: (1) Suspending interventions, which would accelerate the pace of CNY decline and be a further global disinflationary shock, is the most likely outcome, followed by (2) China reverses course and tightens capital controls, which would hit its SDR inclusion chances. The third and least likely outcome is (3) Status quo remains, which would be negative for cyclical assets linked to China. Given our risk assessment, we recommend buying 6M USD call, CNH put spreads, taking advantage of recent PBoC intervention in the forwards to cheapen the insurance cost of this hedge", says BofA Merrill Lynch.