The King of Carry Trades 

Doug Nolan

The Shanghai Composite sank 4.3% this week - and was down as much at 6.7% at intraday Wednesday lows. 

The Hang Seng China Financials Index was down 5.7% at Wednesday’s lows, before closing the week down 3.8%. 

The China’s Financials Index closed Friday down 8.4% y-t-d. 

Hong Kong’s Hang Seng Index dropped 5% this week (9.3% lower at Wednesday’s low), trading down to the lowest level since November.

Chinese private education, real estate development and technology stocks were hammered on a confluence of central government regulatory actions. 

While media attention has been focused on the tech and education crackdowns, more far-reaching policy measures are directed at overheated apartment markets. 

July 28 – Bloomberg: 

“After a years-long campaign to tame property prices, China is upping the ante to break a stubborn cycle of gains that’s made homes increasingly unaffordable. 

In recent days, China jacked up mortgage rates in a major city, vowed to accelerate the development of government subsidized rental housing, and moved to increase scrutiny on everything from financing of developers and newly-listed home prices to title transfers. 

Echoing Xi Jinping’s famous words that ‘housing is for living in and not for speculation,’ Vice Premier Han Zheng added that the sector shouldn’t be used as a short-term tool to stimulate the economy. 

The intensified focus on real estate -- an industry that was already under the scanner -- mirrors broader crackdowns on businesses such as education that are seen as widening social inequities.”

Additionally, from the above Bloomberg article: 

“Another signal came from the unusually large number of government entities that vowed recently to strengthen measures on everything from project development and home sales, to rental and property management services. 

Eight policy bodies said in a joint statement that they would step up penalties for misconduct. 

In the line of fire will be developers that default on debt repayments, delay deliveries on pre-sold homes or elicit negative news or market concerns. Local bureaucrats' careers are on the line. 

Officials in cities that lack sufficient regulations and experience rapid price spikes will be held accountable, Zhang Qiguang, an official for the Ministry of Housing and Urban-Rural Development said on July 22.”

Markets were rattled by Beijing’s aggressive policy approach, despite increasingly unstable securities markets. 

There was confusion, and at least a few analysts voiced a newfound worry: perhaps Chinese leadership no longer cares about market reaction. 

What might this mean for the beloved “national team” repeatedly called upon for the patriotic duty of propping up sinking stock prices? 

Yet, things clearly go beyond domestic policy measures and market reverberations. 

Beijing has adopted a new approach generally – and their determination suggests they’re moving forward irrespective of what anyone thinks. 

They don’t care.

July 28 – Bloomberg (Chang Shu): 

“For decades, China’s economic and financial policy has followed the logic of international engagement and constraints. 

In setting monetary policy, the People’s Bank of China took its lead from the Federal Reserve. 

Seeking capital for growth, major firms aspired to a prestigious U.S. IPO. 

Friday’s meeting of the Politburo confirms that, going forward, China will attempt to chart a more independent course. 

The spirit of China’s new catch phrase -- ‘set our own agenda’ -- pervades the politburo statement, and has far-reaching implications for China’s monetary policy, and engagement with global markets. 

The emphasis of macro policy autonomy in Friday’s statement is in line with our view that the People’s Bank of China is ready to go separate ways from the Federal Reserve.”

A semblance of normalcy seemed to have returned by late Wednesday. 

From Bloomberg: 

“Wednesday’s hastily arranged meeting led by China Securities Regulatory Commission Vice Chairman Fang Xinghai was the latest sign of Beijing’s discomfort with a selloff that sent the nation’s key stock indexes to the brink of a bear market. 

State-run media have published a series of articles suggesting the rout is overdone, while some analysts have speculated government-linked funds have begun intervening to support the market.”

And from Reuters: 

“In a front page commentary on Wednesday, the state-owned Securities Times said that systemic risks ‘do not exist in the A-share market overall.’ 

The macroeconomy is still in a steady rebound stage, and short-term fluctuations do not change the long-term positive outlook for A-shares’…”

Systemic risks might not “exist in the A-share market overall,” yet renminbi volatility Wednesday was beginning to suggest vulnerability for the Chinese currency. 

The dollar vs. renminbi abruptly spiked to 6.51, the high since April 19th. 

Meanwhile, China sovereign CDS surged three points to trade to the highest level (41.5) since April, this after beginning 2021 at 29 bps. 

July 27 - Bloomberg (Jeanny Yu and Livia Yap): 

“A deepening selloff in Chinese stocks spread to the bond and currency markets on Tuesday as unverified rumors swirled that U.S. funds are offloading China and Hong Kong assets. 

The speculation… triggered a late afternoon bout of selling by traders in Asia who had already been dumping stocks in the crosshairs of Beijing’s sweeping regulatory crackdowns. 

The Hang Seng Tech Index plunged as much as 10% in Hong Kong, the yuan slid to its weakest since April against the dollar and Chinese bonds sank. 

The dramatic moves underscored how fragile investor confidence has become after a months-long regulatory onslaught by Beijing that only seems to be getting worse.”

The PBOC was ready to do its part to calm the situation, injecting extra liquidity ($4.6bn) into the system early Thursday. 

The Shanghai Composite rallied 1.5% in Thursday trading, with the growth stock ChiNext Index up 5.3% and the Hang Seng Tech Index surging 8%. 

The renminbi rallied, closing the week up 0.31% versus the dollar to 6.46.

While the renminbi and Chinese stocks mustered a late-week rally, the same cannot be said for key bond prices. 

Behemoth developer Evergrande’s bond (8 ¾ 2025) price sank nine points to a record low 44.7. 

Yields surged 700 bps this week to 36.33%, with a two-week gain of almost 1,400 bps. 

Evergrande yields ended May just below 14%.

An index of Chinese high-yield bonds surged 220 bps to 12.79%, up 310 bps in two weeks to the high since March 2020. 

This index yielded 8.20% at the end of May. 

Developer offshore bonds were under heavy liquidation. 

Easy Tactic bond yields spiked 1,300 bps to 28.9%, and Kaisa Group yields surged almost 500 bps this week to 19.6%. 

Troubled “asset management company” Huarong’s CDS jumped 50 bps, ending the week at a two-month high 1,177. 

Huarong CDS closed March at 149 bps. 

Huarong bonds (5.5% 2025) dropped almost 6 points this week to 73.4, with yields surging 156 bps to 15.79%. 

The week was notable for Chinese contagion gaining momentum. 

Yields for the Bloomberg Barclays Asia USD High Yield Bond Index surged over 100 bps this week, surpassing 9% for the first time since March 2020. 

Yields have jumped 150 bps in two weeks, after trading at 6.65% in late-May.

July 27 - Bloomberg (Ameya Karve): 

“Pain from regulatory crackdowns in China is starting to spread to some of the safest corners of Asian credit, adding to mounting signs of fallout across the region’s financial markets. 

Yield premiums on Asian dollar bonds rose as much as 3 bps Tuesday, traders said. 

That leaves them set for the biggest expansion in over 3 months and for a third straight day of widening, according to a Bloomberg Barclays index. 

The moves mark a shift after such higher-rated securities had been doing better recently, even as junk bonds in the region felt the pinch from rising concerns about Chinese defaults. 

Prices on some Asian high-yield dollar bonds also fell Tuesday, extending losses after recently hitting their lowest levels in almost nine months.”

“Pain… in China is starting to spread to some of the safest corners of Asian Credit…” 

Now that’s a development that should pique our interest. 

Prior to this week, heightened Credit stress was mainly contained within China’s high-yield sector – and for the most part isolated to offshore bond issues. 

But trouble at China’s “periphery” has broken loose – with (de-risking/deleveraging) contagion negatively impacting perceived safer Chinese and Asian Credit. 

This week witnessed an important escalation of mounting global market instability. 

Faith in Beijing took a hit this week. 

Chinese officials have an agenda, and they clearly don’t care as much about global markets – including their offshore bond market – as market participants have wanted to believe. 

But there remains the view that Beijing will ensure adequate system Credit growth and ample liquidity. 

Yet the policy backdrop has clearly become more uncertain and the market environment increasingly hostile. 

The levered players have to rein in risk.

It’s central to my thesis that China has been a hotbed of “hot money” inflows. 

In an era of unprecedented global leveraged speculation, I believe China evolved into the King of Levered Carry Trades. 

How could the enterprising global leveraged speculating community not have gravitated to China’s enticing yields, especially with a currency essentially pegged to the U.S. dollar. 

Better yet, China’s major developers and “AMCs” offered high yields coupled with implicit Beijing backing. 

Resulting market distortions and excess overshadow even those from the U.S. mortgage finance Bubble period.

I believe Beijing today recognizes the Bubble got completely away from them. 

They clearly failed to learn the lessons from their study of the Japanese Bubble fiasco. 

And it is today worth remembering that the Japanese government belatedly moved to rein in Bubble excess in response to increasingly deleterious impacts to equality and social stability. 

While they recognized Bubble risk, they were blind to the degree of financial and economic fragility that had accumulated over the cycle. 

President Xi and his communist central committee must recognize the enormous risk to social stability posed by ongoing Bubble excess. 

Is there any country in the world experiencing a more inequitable distribution of wealth than China?

“Houses are built to be lived in, not for speculation.” 

Difficult for me to believe President Xi has a more favorable view of bond market speculation – a dynamic key to funding fiascos at Haurong, Evergrande and so many others (companies and local governments).

If I had to venture a guess, I would say Xi and friends have had about enough of the current global financial structure. 

Seeing trouble on the horizon, they’re going to attempt to get their house in order. 

Beijing is coming down hard on speculation – in stocks, apartments and bonds. 

They’ll assume state-directed bank lending and deficit spending can ensure adequate Credit growth to meet growth objectives. 

But if they recognized the degree of underlying fragility, they would have moved years ago.

This week, I heard analysis that Chinese reform efforts are a positive development, ensuring long-term growth and stability. 

I recall similar commentary regarding the tightening of U.S. subprime mortgage Credit back in late-2007. 

Arguably long-term constructive, but not before unwieldy end-of-cycle excess followed shortly by a collapsing Bubble. 

July 30 - Bloomberg (Rebecca Choong Wilkins): 

“China’s riskier dollar bonds once beloved by global investors for their juicy yields are now dragging down returns. 

Single B rated notes have lost 17.5% this year, spurring a 7.3% retreat among the broader universe of junk debt... 

Fresh property curbs and China Evergrande Group’s cash woes have this week pressured some newly issued developer bonds, which dominate the region’s junk debt. 

‘This fragile sentiment toward property HY would likely persist in the near term,’ according to a note from ICBC International analysts led by Angus To.” 

How gigantic is the Chinese levered “carry trade”? 

How much “hot money” has flooded into Chinese stocks and bonds over recent years? 

China has provided the marginal source of global Credit. 

I suspect leveraged speculation in Chinese bonds has been integral to global liquidity excess. 

This week was important. 

Collapsing bond prices for a group of companies with over $1 TN in combined liabilities. 

Chinese high-yield bonds trading as if almost the entire sector was going bust. 

Renminbi vulnerability revealed. 

Contagion jumping to Asia and EM more generally. 

Confirmation that China’s Bubble has been pierced, with dire ramifications for Bubbles across the globe. 

July 28 - Bloomberg (Ye Xie and Christopher Anstey): 

“You’re in good company if you can’t figure out why U.S. Treasury yields are tumbling. 

Jerome Powell isn’t sure either. 

Bonds have relentlessly rallied for months, even as inflation spikes to 13-year highs. 

Textbooks and Wall Street lore say yields should be jumping instead of diving in the face of that. 

The Federal Reserve chairman weighed in on the puzzle when asked about it Wednesday. 

‘We’ve seen long-term yields come down significantly,’ Powell said at a press conference… ‘I don’t think that there’s a real consensus on what explains the moves between the last meeting and this meeting.’”

I relate to Rob in the Workday commercial, who keeps yelling “Workday” during a Zoom call when his coworkers are trying to explain why they’re losing business to a competitor. 

Why have Treasury and global bond yields been collapsing in the face of surging inflation? 

The faltering Chinese Bubble. 

The Faltering Chinese Bubble! 

Fragile global Bubbles!!! 

“Hey Doug, you’re on mute.”

The Fed missed another opportunity this week to get the process started. 

Treasuries (10-yr yields down 5 bps this week to 1.22%) are essentially signaling it’s over before things even get started. 

Powell’s post-meeting press conference was considered dovish and (like Chinese policymaking) confusing. 

The Fed’s in a real pickle here. 

Powell is struggling to justify ongoing historic monetary inflation in the face of the most intense inflationary shock in decades. 

Our Fed Chair has the Republicans breathing down his neck, along with an increasingly divided (and vocal) FOMC. 

Public confidence is in the greatest jeopardy since the seventies. 

It’s an especially precarious position, especially considering the unfolding global backdrop.

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