BofAML's Woo Explains How China Was Behind One of This Week's Most Extraordinary Market Developments

Why it was a brutal week for risk parity

One of the more puzzling events that occurred this week was the failure of long-dated Treasuries to catch a bid while the bottom was falling out of stocks. At times when the Standard & Poor's 500-stock index was plunging on Tuesday and Wednesday, the yield on the 30-year U.S. Treasury bond actually made a move higher, the opposite of what you'd expect when investors are scrambling for a safe haven to park funds in a time of market turmoil. You can see the strange action depicted in the below chart, which compares the yield on 30-year Treasuries (the white line) with S&P futures (the green line). The red-shaded area shows the period of disconnect.

Source: Bloomberg

During an interview on Bloomberg TV, David Woo, Bank of America Merrill Lynch's head of global rates and currency research, explained that this curious price action has its roots in Chinese policy.
"I would argue the insensitivity of Chinese interest rates and U.S. interest rates to equity volatility are actually very much connected; in fact, they're directly linked," he said.
Chinese intervention in foreign exchange markets to prop up the value of the renminbi, Woo argued, is at the heart of this price action.
To mount a defense of its currency, China first has to divest Treasuries and then exchange the U.S. dollar proceeds for renminbi. This practice puts upward pressure on U.S. Treasury yields. So in a period when investors normally flock to the safety of U.S. debt and drag yields lower, the largest foreign holder was selling.
The rare positive correlation between stocks and bonds in a period of market stress that ensued wreaked particular havoc on a market strategy—risk parity—that has risen in prominence over the past few years. In general, practitioners of this strategy use leverage to generate equity-like returns from fixed income.
"They're banking on the negative correlation between these two to work for them during periods of stress," he explained. "This is why they generally run a relatively low-volatility portfolio, which is the reason why they tend to be very leveraged."
The weakness in both of these asset classes was exacerbated as these funds were forced to liquidate risk across the board in order to limit potential losses, said Woo.
"From that point of view, I would argue you go from a straight line to China defending the renminbi to risk parity guys doing poorly," he concluded.
The end game, says Woo, is a free-floating Chinese currency, which will provide monetary policymakers the necessary freedom to give sufficient support for the stock market and real economy.
"If it wants to lower interest rates—which is something China needs to do, is desperate to do—they need to let the currency go," Woo said.
A free-floating Chinese exchange rate would likely spark competitive devaluation across Asia and another leg downward in commodity prices. As such, Woo concludes that it is a highly deflationary event that will push the Federal Reserve's first rate hike even further out into the future.
Though timing any liberalization of the exchange rate is difficult, Woo suggested it could come following the upcoming military celebration and Xi Jinping's visit to the U.S.