Since 2000, China has bought massive quantities of U.S. Treasury bonds to balance its trade surplus.
In total, China has amassed approximately $1.27 trillion worth of U.S. Treasury bonds, or about one-quarter of all bonds held by foreign governments.
Naturally, China’s Treasury purchases have put downward pressure on rates. Here’s a long-term chart of 10-year Treasury rates, which have been driven down from 6.8% in 2000, to as low as 1.4% in July 2012.
Treasury rates have bounced up and down within a well-defined channel since the 1990s. And as you can see in the blue box above, we’re now at the upper boundary of the channel once again.
Keep in mind, this channel is not predictive. Just because rates have approached the upper boundary, it in no way guarantees that rates will fall.
If China significantly reduces its purchases of U.S. Treasury bonds, rates would shoot higher, making a bullish breakout from the downward sloping channel and likely usher in a new era of rising rates.
That scenario isn’t far-fetched. Last year, Chinese purchases of U.S. Treasury bonds came in about 30% lower than in 2012. Meanwhile, 10-year rates rose sharply in 2013.
Here’s a short-term chart of 10-year rates, covering the time period highlighted in the blue box above.
As you can see, rates jumped from 1.66% in May to 3% in September, as the Fed was vocal about its plans to taper its bond purchases while China was already slowing its purchases.
But if rates are to continue higher and break above 3%, it seems they’ll pull back first. The 10-year rate has trended downward in all of 2014 and appears to have further to fall.
Particularly now that stocks have been weak through the first two months of the year, combined with geopolitical tensions around the world, safe-haven Treasury buying should push rates a little lower in the near term.
In the long-term… we’d better keep a close eye on China’s Treasury purchases. If China tapers alongside the Fed’s taper, we could see rates north of 3% later this year.
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