There is a new player to watch on the global monetary policy field: the PBOC.
The People’s Bank of China’s policy moves in the coming weeks and months could have large implications for the monetary policies of other major central banks and have a profound impact on asset prices globally. Our expectations for the PBOC’s policy path will be a key topic of discussion during PIMCO’s Cyclical Forum next week.
China’s decision to relax the yuan’s quasi-peg to the U.S. dollar and allow the currency to depreciate was a key contributor to market volatility over the past few weeks. While Chinese authorities probably had a small move in mind, the market’s fear of a potentially bigger devaluation led to large capital outflows and tighter liquidity conditions in China. In the face of such uncertainty the PBOC had to respond with large liquidity injections and currency intervention.
The key question facing investors now is where the yuan will ultimately settle. The answer depends on which of two possible approaches the PBOC adopts: Decrease interventions and let the yuan find its “equilibrium,” or continue to intervene heavily in an effort to keep the currency strong.
In the first scenario, the yuan weakens over the short term. A weaker yuan is likely to be followed by weaker currencies in emerging Asia, which in turn could lead to a corporate earnings boost in those countries. In contrast, weaker Asian currencies could put pressure on exports from Japan and Europe, affecting corporate profits and equity valuations in those areas. Finally, if the U.S. dollar strengthens, it could be a factor in the timing of the Federal Reserve’s decision to hike which could result in a rally for U.S. bonds.
In the second scenario, the PBOC will need to sell reserves (primarily U.S. Treasuries) to defend the yuan. The major impact would be higher U.S. interest rates. But when the PBOC intervenes, the U.S. dollar proceeds used to purchase the yuan will land in the hands of private agents whose risk tolerance is much higher. They are likely to invest these proceeds in far riskier assets such as corporate bonds, equities or real estate. While this is good news for risk assets, the PBOC’s policy actions could again have implications for Fed policy.
Next week, as we review our near-term outlook for the global economy, we will carefully consider such potential ripple effects of the PBOC’s policy alternatives.