The ripple effect of the Chinese slowdown

Massive amounts of capital are leaving China, driven variously by fears of a slowdown, of a falling yuan and of a corruption crackdown, with some estimates putting the figure for 2015 at or above $1 trillion.

As capital leaves, China's foreign exchange reserve managers must either sell some of the $3.3 trillion in assets they have stockpiled or allow the yuan to weaken. As a weakening yuan, while helping exports, can become a self-fulfilling spiral, China has resisted allowing market forces to play their role.

"It's ridiculous. It's impossible," Han Jun, deputy director of the office of the Chinese Communist Party's Leading Group on Financial and Economic Affairs, said last week.

"China still maintains a huge capital inflow," Han added.

China's resolve to support the yuan implies further selling of U.S. assets, particularly Treasuries but also corporate and other types of debt. As bonds are sold, it will press yields higher than where they would otherwise settle.

That's not to say U.S. interest rates will go up; the overall impact of China is clearly deflationary. Instead, the normal boost the economy might get from falling Treasury yields will be blunted. Treasuries, on some measures, had their strongest opening week of a year ever in 2016, while stocks had their weakest. Yet Chinese selling may actually have capped bond price gains as well as the fall in yields.

This also underscores the extent to which the Federal Reserve, which raised interest rates for the first time in a decade in December, faces challenges to its control over yields, which are its principal means to steer the economy.

"Last week we saw a global sell-off in stock markets apparently triggered by data from China that fell short of expectations."

Data last week showed China's foreign exchange reserves fell by the most on record, $108 billion in December alone. Reserves dwindled by more than half a trillion dollars for the year.

Bank of America Merrill Lynch (BAML) estimates that China sold $292 billion of U.S. Treasury debt last year as well as $3 billion of U.S. agency bonds and $170 billion of non-U.S. assets. BAML on Monday predicted that U.S. corporate bonds could prove vulnerable to Chinese sales. China holds more than $400 billion of U.S. corporates, the bank estimates.

Swap spreads, the extra that an investor gets for accepting a floating payment from a bank rather than a Treasury yield, have narrowed in recent weeks, a trend tied to Chinese selling. As of Monday, two-year swap spreads were down to nine basis points, as compared to about 24 basis points a month ago.

At various points last year swap spreads were actually negative, a bizarre condition considering that banks are far riskier counterparties than the U.S. government.

This is really simply the flip side of the phenomenon of Chinese reserve accumulation over the last 15 years, a trend that arguably also drove U.S. interest rates too low, despite Fed efforts. That was one of the underlying causes of the U.S. housing bubble, and may also have contributed to the earlier dot-com bubble, as investors took on risk and borrowers found money too cheap not to borrow.

Still, it is important not to understate the extent to which China's management of its foreign reserve assets can complicate U.S. economic management, not to mention muddy the waters in global financial markets.

China, a great importer of raw materials and exporter of finished goods, is sending deflationary waves globally already. That China might depress demand for U.S. products while at the same time, on the margins, raising the cost of financing for dollar-based borrowers only makes the Fed's position more thorny.

Chinese selling of Treasuries and other fixed income will also tend to upend investor expectations of how their portfolios will perform in times of market stress.

With no signs that capital flight pressure will diminish, China will remain one of the main market and economic risks in coming months.