The Chinese connection revisited

If we overlay the JPY/CNY exchange rate on U.S. 10-year note rates, we see a fairly strong directional correlation between the beginning of the CNY’s controlled float in July 2005 and Feb. 3. The more the JPY weakened against the CNY, the higher U.S. note rates rose. A cynic might assume the Japanese were content with this competitive devaluation and therefore felt less need to intervene in the currency market by buying U.S. Treasuries. And if the JPY firmed, as it did after Dec. 7, the interventions resumed.

The JPY is no longer weakening against the CNY. With the USD cheaper in JPY terms and with the yen carry trade still profitable, why would the Bank of Japan not start buying U.S. Treasuries again? It serves the interests of all three countries. Japan finances its and China’s customer, the U.S. gets lower interest rates, and the Chinese can take their time in allowing the CNY to appreciate further.

Traders in general, and Treasury traders in particular, find simple explanations and bilateral relationships comfortable. They focus on simple things such as the Bank of Japan raising short-term rates by a meaningless handful of basis points or on the JPY-USD rate. Currencies and bonds form a unified and multilateral system across all segments of the yield curve. We need to focus on as many relationships simultaneously as we can and consider how the bilateral relationship between China and Japan affects the U.S. Treasury market. As China and surely India increase their role in international trade and finance, this need will grow, not shrink.

A simple focus has led many toward the knee-jerk trade of selling U.S. Treasuries on the yen carry story. We suggest the yen carry trade will remain and unless Japan is willing to accept a stronger JPY vis-à-vis the CNY, Japanese purchases of U.S. Treasuries will accelerate.

Currency traders, in turn, can focus on the JPY/CNY cross rate and its relationship to the U.S. Treasury market. The more this arbitrage relationship is understood, the greater the potential to profit.