April 17

China Is Holding Back the US Dollar

During my experience on an interbank trading desk, the locations of “ACB”  (Asian Central Bank) orders were coveted secrets. The main ACB is of course the Peoples Bank of China. The PBoC manages its FX reserves through various shadowy custodians and sovereign wealth vehicles.  The method these central banks use is staking out a particular level and buying every time price dips there. These orders aren’t placed in the order books with any major interbank dealers, the massive flow is all on demand and suddenly hits the market when price trades to their desired level.  This type of flow explains why in recent weeks EURUSD may be falling, then suddenly trades into a supports and massively ramps in the other direction by 60 points.

This shadowy style of dealing makes it tough to buy the Dollar. Central bank flows are huge and move the market significantly as dealers step out of the way and withdraw liquidity. During 2012 it was common for the Swiss National Bank to be on the offer in EURUSD as they diversified a build up of EUR FX reserves that were acquired as the SNB enforced its 1.20 floor in EURCHF. Dealers were constantly whispering about where the SNB offers were, because they knew it was a safe bet to sell in front the SNB. Fortunately with the SNB, things were much more above board than with the PBoC. Most SNB flows came through Rabobank, so whenever that name appeared on the offer dealers knew within a reasonable doubt that the SNB was selling Euros.  The case with China is different because they have so many entities to do their bidding (pun intended).

China’s FX reserves are the largest single pool of money in the world and that effectively makes China one of the largest movers of FX markets. The goal is to keep their FX reserves around 60%-70% in US dollars. In Q1 2014 China’s FX reserves rose $129bn to 3.9tn total. Ironically this huge rise in FX reserves occurred when their trade balance was actually nearly flat for the quarter. This lets on that China is printing hundreds of billions of Dollars worth of Yuan to intervene in the FX markets. It was thought during most of the first quarter that the huge move higher in USDCNY was started by the PBoC buying USDCNY, but that outflows of hot money were the main culprit behind the continued grind higher in USDCNY. That may not be the case.

If you compare the charts below you will see that for the most part, increases in China FX reserves have occurred when the trade balance was very high. This is how FX reserves are increased, when there is a trade balance surplus the excess shows up in the FX reserves because China manipulates its currency to keep the Yuan’s value artificially low. Look at how the early 2012 trade deficit corresponded to the only significant drop in FX reserves  on the chart. However if you look at the trade deficit that occurred in the first quarter of 2014, it corresponds to a huge increase in FX reserves. Something went on here that clearly is not normal.


The fact that FX reserves expanded by $129bn during a quarter in which the total trade surplus was about $16.5bn signifies that China may still be selling CNY, effectively printing Yuan to debase its currency… Bernanke style. They widened the Yuan band and patted themselves on the back for letting the markets have more control only to vastly increase manipulation of their exchange rate. Obviously President Obama isn’t happy with these developments and the treasury commented on the falling Yuan this past Tuesday.

Recycling the US Dollars bought during this intervention that began February 24th is a going to be a grind. If 25% of the total increase in FX reserves is diversified into other G10 currencies, that’s $32.3 billion in US dollars that need to be sold with the majority of it being accumulated since late February. An almost endless supply of USD explains why the Dollar simply cannot rally over the past six weeks. Additionally the $97bn thats kept in USD provides a massive bid for US bonds that keeps US yields down, stifling the attractiveness of the USD. The sizes of the flows from China dwarf any speculative discretionary money, especially with bank desks taking on less risk in the face of regulation and investigations. Until there is significant momentum in the US dollar moving higher,the big real money investors and momentum driven speculators are likely to follow China in selling the Dollar no matter how good the US data is. Until China finishes intervening in USDCNY, building Dollar longs will be tough.