Fed rate cut, foreign investors to sell short-term bonds?

Facing the Fed rate cut and the weakening US dollar, the Renminbi may enter a phase of appreciation. The previous appreciation of the Japanese Yen triggered a reversal in carry trades, causing significant volatility in overseas markets. Investors are also concerned whether Renminbi appreciation will lead to foreign capital selling domestic short-term bonds, impacting the domestic bond market. In this context, we will clarify this issue from the following perspectives.

First, what is a forward contract? What are the differences between forward contracts and forex margin trading? Forward contracts do not involve leverage.

Renminbi foreign exchange forward trading involves the exchange between Renminbi and foreign currency, with agreed currencies, amounts, near-end exchange rates and value dates, as well as far-end exchange rates and value dates. By exchanging with banks based on the agreed near-end exchange rate and value date, and simultaneously agreeing on the far-end exchange rate and value date for reverse exchange, forward contracts are mainly used to hedge against exchange rate fluctuations by locking in forward rates to mitigate risks and secure profits in advance.

Compared to forex margin trading where "small bets lead to big gains," with risks and profits expanding simultaneously, the purpose of forward contracts is to hedge against exchange rate risks, without additional leverage, making it a more conservative trading type.

Second, with the inversion of the US-China interest rate differential, why are foreign institutions increasing their holdings of domestic bonds? The forward market provides excess returns.

For forward contracts, the key lies in determining the forward exchange rate. Generally, according to the interest rate parity theory, the forward exchange rate can be calculated based on the interest rate differential of government bonds of the two countries with the same maturity and the spot exchange rate, i.e., (1 + interest rate differential of government bonds with the same maturity in both countries) = forward exchange rate/spot exchange rate. In the context of forward markets, the difference between the forward exchange rate and the spot exchange rate is known as the forward points. However, in reality, the interest rate parity theory may not always hold true, leaving room for arbitrage opportunities beyond the theoretical framework.

For example, on July 31, 2024, the closing price of the 1-year USD/CNY forward points was -2892, with a spot exchange rate of 7.2261, resulting in a corresponding forward exchange rate of 7.2261-0.2892=6.9369. This implies an implied interest rate differential of -4.00%, while the 1-year US-China government bond interest rate differential was -3.31% at that time, indicating an excess interest rate differential of 69 basis points.

In the forward market, foreign investors engage in 1-year forward contracts, selling USD at the spot rate to acquire CNY, and investing in 1-year Chinese government bonds. Upon maturity, they reverse the exchange based on the pre-agreed forward rate, earning a return of 5.42% (4.00% + 1-year government bond yield), higher than the 4.73% return on investing in 1-year US bonds. Investing in 1-year interbank certificates of deposit can yield as high as 5.88%.

The existence of excess returns can attract USD inflows into the domestic market, stabilizing exchange rate expectations. Amid Renminbi depreciation, the willingness of export enterprises to settle in foreign currency is low, and these excess forward points provide banks with additional sources of USD liquidity.

From a symmetrical perspective, while foreign institutions exchange USD for excess interest differentials, Renminbi holders exchange for USD, incurring excess interest differentials to lock in forward rates. Deducting the hedging costs, investing in US bonds yields lower returns than investing in domestic Renminbi bonds, helping to reduce domestic capital outflows Overseas institutions continue to increase their holdings due to excess interest rate differentials. Since September 2023, foreign capital has continued to increase its holdings of domestic bonds against the backdrop of an inverted yield curve between China and the United States, with custody increasing by 1.1314 trillion yuan. The main reason is to lock in higher returns relative to U.S. bonds through the forward market. As of September 6, 2023, to August 23, 2024, the implied excess yield spread for investing in 1-year government bonds has consistently exceeded 30 basis points, with a median of 67 basis points.

The median excess yield spread for investing in 1-year interbank certificates of deposit is even higher at 107 basis points.

Third, do overseas institutions sell domestic bonds bought through foreign exchange forwards to lock in forward exchange rates due to spot rate appreciation or interest rate fluctuations? Most existing transactions will not be affected.

Due to the locking in of forward exchange rates, the investment returns for holding 1-year government bonds and interbank certificates of deposit until maturity are also locked in. Therefore, future spot exchange rate fluctuations and interest rate fluctuations will not affect these existing transactions. If foreign investors choose longer maturities when investing in domestic bonds, they may be affected by significant fluctuations in long-term bond rates.

However, considering that since the fourth quarter of 2023, interbank certificates of deposit accounted for 65.8% of the increased holdings of domestic bonds by overseas institutions, there may still be some short-term government bonds, and it is speculated that the proportion of medium to long-term bonds is not high. Therefore, spot exchange rate fluctuations or interest rate fluctuations will not affect most existing transactions, but will mainly affect the inflow of incremental funds.

Recently, the Renminbi has appreciated in stages, with the forward points returning from around -2900 points to within -2300 points. For foreign capital, the excess returns from covered interest rate parity have narrowed to within 50 basis points, and the pace of incremental foreign capital inflows into the domestic bond market may slow down.

Fourth, how does carry trade with the Japanese Yen differ? It is in the opposite direction, where the Japanese Yen carry trade can achieve higher returns by taking on exchange rate risk.

In early August, Japanese stocks experienced a sharp decline, leading to a shift in carry trades. Major developed economies such as the United States and Europe have raised interest rates for over two years, generally in a high interest rate environment, but the Bank of Japan only recently raised interest rates, making it one of the few low-interest currencies in the past two years and a rare liability currency for carry trades.

Investors borrow low-interest Japanese Yen (shorting the Yen), buy high-interest currencies such as the U.S. Dollar, not only to earn interest rate differentials, but also to benefit from the depreciation of the Yen driven by the high interest rate differential between the U.S. and Japan. By not locking in forward exchange rates and taking on exchange rate risk, carry trades can earn additional exchange rate gains. The expectation of a stronger Yen due to the interest rate hike in Japan erodes the exchange rate gains, leading to short covering of Yen positions and causing Yen volatility.

In comparison, overseas investors borrow Japanese Yen, exchange them for high-interest currencies like the U.S. Dollar in the spot market, and gain from interest rate differentials and the depreciation of the Yen (unhedged funds). Investing in Chinese bonds is a reverse trade, where overseas investors lend U.S. Dollars, exchange them for Renminbi in the spot market, and lock in the implied excess yield spread from the forward market.

During periods when the yield spread between China and the U.S. is positive and there is an expectation of Renminbi appreciation (certain periods between 2017-2019), overseas institutions buy Chinese bonds. Some overseas investors choose not to lock in forward exchange rates and take on exchange rate risk to gain excess returns from Renminbi appreciation This type of actively managed fund may be relatively vulnerable to exchange rate fluctuations, but most of these funds may have already flowed out of the domestic bond market during the 2022 Fed rate hike process.

Fifth, under what circumstances have foreign institutions reduced their holdings of Chinese bonds historically? Will a Fed rate cut lead to foreign investors reducing their holdings of Chinese bonds?

Foreign investors reducing their holdings of domestic bonds mainly occurred in two phases, corresponding to the depreciation of the exchange rate, narrowing of the interest rate spread, and even deepening inversion. First, from August 2015 to February 2016, after the 8/11 exchange rate adjustment, the RMB exchange rate underwent a phase of adjustment, with foreign investors reducing their holdings of domestic bonds for seven consecutive months by 131.1 billion yuan, accounting for approximately 20.1% of the total outstanding amount;

Second, from February 2022 to April 2023, during the Fed rate hike process, the short-term interest rate spread between China and the US dropped from over 200 basis points to around -300 basis points. In 13 out of 15 months, foreign investors continued to reduce their holdings, with a total decrease in custody volume of 903.5 billion yuan, accounting for approximately 22.2% of the total outstanding amount.

The situation ahead does not necessarily involve foreign investors unilaterally reducing their holdings of Chinese bonds. The Fed is about to enter a rate-cutting cycle, the passive depreciation pressure on the RMB is easing, and the degree of inversion in the China-US interest rate spread is expected to narrow. In this context, foreign investors are unlikely to turn to reducing their holdings of Chinese bonds, because there are two channels with opposite directions: one is the narrowing of forward points, which may lead to a decrease in the inflow of foreign funds into the domestic short-term bond market through the forward exchange market;

The other is that if the RMB enters a period of volatile appreciation and the degree of inversion in the China-US interest rate spread narrows, in order to obtain RMB appreciation gains, some foreign investors may continue to flow into the domestic bond market.

Author: Xiao Jinchuan (S1120524030004), Source: Yu Yan Bond Market, Original Title: "Will the Fed Rate Cut Lead to Foreign Investors Selling Short-term Bonds?"