U.S. treasury yields surpass China, but what does it mean for Interest Rate Parity?
U.S. treasury yields surpass China, but what does it mean for Interest Rate Parity?
On Monday April 11 2022 – for the first time in twelve years – the spread between Chinese 10-year bonds and the comparable US Treasury didn’t just close, but turned negative. Last occurring in June 2010, our experts explore what this means for U.S. vs China Interest Rate Parity.
For years, Chinese government bonds had paid significantly higher yields than US Treasuries. This has been a major attraction for international investors. However, that advantage has since disappeared. The yield on the 10-year US Treasury closed at 2.779% on Monday, April 11, 2022, while the yield on China's 10-year government debt closed at 2.767%.
Fundamentally, we know the economic relationship between risk assumption and return generation; the more risk assumed, the greater the return. This then brings up a key question: what may we (frighteningly) deduce from this current global assessment of essential parity between the US and China's ability to borrow 10-year funding?
The Reasoning Behind Rates
Personally, I wouldn't read a tremendous amount into what some may see as cause for concern, and this is for a couple of reasons:
First, when we're talking about the return on U.S. Treasuries, the general assumption is that they are the risk-free rate. Here we're talking about the nominal rate as opposed to the real Treasury Inflation-Protected Securities (TIPS) rate. So the first implication is actually a good one. China's debt would appear to be risk-free as well, assuming all other things are equal.
Now, the other question here is whether the Chinese rate is quoted in dollar-denominated bonds or in yuan. If the latter, then we need to worry about expected changes in the exchange rate. If there was no expected change in exchange rate, then the expected rates would be equal and we could conclude that there's no risk premium in either rate.
Japanese Bonds as a Case Study
However, Japanese bonds come in at 0.25%. That suggests that all the rates quoted are in nominal terms and are in the domestic currency – the standard way that rates are generally quoted. But then we need to return to Interest Rate Parity. That is, we should expect interest rates across countries to be equal if two conditions hold:
Both are risk-free so there is no risk premium involved in the comparison,
And, both countries have the same rate of expected inflation.
At the moment, it’s likely that we are expected to have more inflation whereas Japan is expected to have less. And that should impact the interest rates.
From an equation perspective,
r(US)=r(J)+RP+e (change in ER)
is the basic interest rate parity equation where RP is the risk premium and e (change in ER) is the expected change in the exchange rate over the length of the rate.
If RP=0 for Japan, then we can take
r(US)-r(J)=e(change in ER)
Bottom line; from that spread, we can calculate the expected change in the exchange rate, and presumably at the moment markets expect the value of the dollar to decline by about 2.5% relative to the Japanese yen. (It's a bit more complicated looking at 10 years vs. 1 year but the key takeaway is fundamentally the same.)
The Truth in the Timing
We can now turn and ask what determines whether we should expect the exchange rate to rise or fall. In the short term, there's a lot of focus on short-term GDP growth, but fundamentally that's mistaken. In any one quarter or year, maybe we'll have growth of 4% or 1%, but realistically over any longer-term period in the U.S., we should expect about 2.5%. (Actually, under Democratic presidents we should expect about 3% and under Republicans, we should expect a bit less than 2%, but I'll ignore that twist!)
Similarly, Japan and China are going to have a base growth rate that may fluctuate. However, all those growth rates are pretty much locked in by long-term factors, like the size of the capital stock, labor force and training and productivity. Just look at the potential GDP time series and you'll see that pretty dramatically.
The implication? Return to the interest rate parity condition. What drives the expected change in the exchange rate? In the short term, changes in GDP growth may play a role, but over longer periods, those are locked in and the only thing left is inflation. (Generally, when we talk about GDP it's real GDP, but what matters in this case, is nominal GDP and the inflation component in particular.)
So why do we see the 0.25% rate for Japan and the 2.75% rate for the U.S. and thus expect to see a 2.5% decline in the dollar relative to the yen? In a word; 2.5% higher inflation in the U.S. That shouldn't be a surprise at this point.
Now if we take that analysis to China, the rates are the same but there are two things that could differ: RP or e(change in ER). I expect that there's still some positive RP associated with Chinese bonds. Say, for example, it's 2%. The interest rate parity equation would then indicate
2.75=2.75+2+e(change in ER)
That would suggest that the yuan was expected to depreciate by 2%.
The Bottom Line…?
Just one final complication: How trustworthy do we deem the figures that the Chinese government produces on GDP? My thoughts are that China has had a higher interest rate, in part, because of a risk premium.
Certainly, if I were buying Chinese bonds I would personally demand a risk premium. In my opinion, I don't think that has changed appreciably. So why the relative drop? Likely due to a drop in their expected inflation and GDP growth relative to the U.S. for the reasons given above.
Ghostwritten for MountainView Risk & Analytics in April 2022
