The Chinese Sleeping Giant Awakens – Capital Flows, Global Bonds and 1987 Redux?

by Michael J. Howell9. March 2017 16:14

As the Chinese and Eurozone economies gain traction, inflation pressures are building. Global bonds must come under further pressure. Yet, inflation is only half the story. Most of the collapse in bond yields in recent years was driven by capital flows: a hefty US$4 trillion-plus poured into US Treasuries, the US dollar and other ‘safe’ assets from ‘offshore’. Central Bank QE policies may have contributed, but they cannot explain the size of the flows. We argue that these flows are economically-related, highly cyclical and already reversing. In February, China actually saw net capital inflows again. They threaten much higher bond yields ahead by forcing depressed bond term premia back up . Capital flows appear to explain most of the 400bp swing in bond yields, more than fluctuating inflation. A reversal could stretch equity valuations like in 1987 and lead to a broader sell-off in ‘safe’ assets. It is predominantly these ‘safe’ assets whose prices look out-of-line. In short, risk may come from where you least expect it. It is critical to understand this capital flow story.


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