How the US China trade war caused the bond bubble

China has none of these institutions. It doesn't have an internationally respected Central Bank, and it hasn't built an international network of banks and banking support services. What it has tried to do is go through official channels. Through the IMF, it's had the RMB included in the basket of currencies used by the IMF, called the Special Drawing Right (SDR). In addition, it has provided through the IMF, a series of currency swaps in which it has swapped the RMB with the currencies of other central banks, that are part of the SDR. As a result, it has built up its international reserves and the proportion of international reserves that are in RMB. Still, they were doing this from an incredibly low base.

Even as short a time ago as the 2^nd quarter of 2017, the RMB was only 1.07% of international reserves. This was a lower number than the Australian dollar had at that time. Table 1 shows us in the most recent time period, which is the first quarter of 2019, we see that the total proportion of international reserves held in RMB is still only 1.95% of total reserves. This is only slightly higher than the proportion held in CAD of 1.92% and the proportion held in AUD of 1.67%.

Even though China has been attempting to build up the RMB as a reserve currency, the proportion of international currency in RMB is less than half of the Pound Sterling at 4.54%, or the Japanese Yen at 5.25%. It is around about a tenth of the proportion held as Euros, which is 20.24%. The proportion of international reserves held in RMB is vastly lower than the overwhelmingly dominant international currency, the US dollar: 61.8% of all international reserves are held in the US dollar. In spite of all its efforts, the RMB is only a minor player in international reserves and international finance.

Trade War?

What happens when you have an international confrontation over trade between the US and China? What's supposed to happen, theoretically, is if a country puts up its tariffs relative to that of another country, that puts up its terms of trade. That means its exchange

rate goes up against the country, on which its increased tariffs. Back in March 2018, Donald J Trump, President of the US first increased the tariffs on imports of Chinese goods into the US. The USD should have started to go up, and the Chinese RMB should have started to go down. That's exactly what happened.

The RMB $US exchange rate is shown in Figure 1. The RMB peaks, relative to the USD in February 2018, immediately before the US starts to put up tariffs on imports of Chinese goods into the US. The RMB has been on average falling ever since. And as it falls, international reserves and international trade finance, which is held in RMB, is being sold and used to buy US treasury bonds.

Up until March 2018, our model of US bond yields was going up, based on the rise in the US Fed funds rate. Since the capital flight from China into US treasuries began in March 2018, we have seen an unanticipated but major decline in US treasury bond yields. This decline is shown in Figure 2.

That decline in US treasury bond yields (since the US 10 Year bond is the benchmark bond of the world) has led to a decline in all the bond yields in all of the countries which have advanced economies. We have seen a dramatic decline in Australian 10 Year bond yields, down to an all-time record low yield. This has happened just slightly after, but a direct result of, the decline in US treasury yields.

Our bond models, based on normal market conditions, tell us that we now have a situation where Australian 10 Year bond yields are 2.4 standard errors below where they should be in terms of yield, and US 10 Year bond yields are 2.7 standard errors below where they should be in terms of yield. This means that US 10 Year bonds, for example, are in an area where they are a little over the top one percent of possible valuations, as a matter of fact, Australian 10 Year bonds are the same.

Conclusion

These very low levels of bond yields have been caused as a result of the capital flight from RMB securities into US bonds as a result of the fear engendered by the trade war.

The major effects of the trade war seem not to be on trade but on financial confidence. Loss of financial confidence in the RMB is generating a flight out of RMB securities into US bonds. This has driven down the level of US bond yields.