From the WSJ's daily Credit Markets column:
China's decision to revalue the yuan helped send U.S. interest rates higher, but the mystery surrounding the move left many investors wondering what the longer-term effect, if any, may be on the price American consumers and companies pay to borrow for everything from homes to new factories.
The two biggest questions for bond investors: Exactly how will the Chinese central bank set the value of the currency, and will further revaluations follow in China or elsewhere in Asia.
News of China's revaluation, which long had been expected, didn't immediately cause the financial dislocations that some had feared. But it caught many in the bond market off guard. "It was pretty spectacular," said Jason Evans, head of Treasury trading at Deutsche Bank Securities in New York. "There has been some acute confusion with regards to exactly what is being done here."
Uncertainty over the details and a new round of bombings in London initially kept some investors on the sidelines. But heavy selling later pushed the yield on the 10-year Treasury note above 4.28% in New York. Late yesterday afternoon, the 10-year Treasury note fell 28/32 to 98 26/32, or $8.44 for each $1,000 of face value, to yield 4.276%. The 30-year Treasury bond slid 1 22/32 to 113 9/32, to yield 4.497%.
Investors sold Treasurys on the expectation that China, under a new exchange rate, won't need to buy as many dollars to keep its currency and exports inexpensive in dollar terms. With less dollars to invest, China may curb its appetite for U.S. bonds, pushing prices down and yields up.
If other Asian nations follow suit, the effect could be magnified. "I think there's a bit of fear out there as to just how far this might end up going," said David Glocke, a portfolio manager at The Vanguard Group, an asset-management firm based in Valley Forge, Pa.
According to the U.S. Treasury, Asian investors plowed about $37 billion into Treasurys in the first five months of 2005 -- much less than in the year-earlier period, but still significant. Analysts have estimated that U.S. long-term interest rates could be as much as one percentage point higher without the Asian demand.
As of yesterday, though, only Malaysia had announced plans to join China in revaluing. Bond-market professionals note several reasons Treasury prices already may reflect the potential effects of China's move. First, the market long has expected a revaluation. Second, the initial move, at least, was relatively small: China will raise the yuan's value against the dollar by only 2.1%, then allow it to float in a tight band around that new value. Third, China and other Asian nations have been diversifying their hard-currency reserves away from dollars.
Also, bond investors in recent months have been much more focused on the U.S. economy and on the U.S. Federal Reserve's interest-rate policy than on China's monetary policy. "I think there was a lot more focus on [China] six months to a year ago than there is today," said Bill Kohli, a portfolio manager at the Putnam Diversified Income Trust in Boston.
Two areas of uncertainty remain: The composition of the basket of currencies to which China plans to peg the yuan, and the extent to which China will allow its currency to rise further against the dollar. If the dollar plays a minor role in the basket, or if China's move proves to be the first step in a larger revaluation, the country's demand for U.S. currency and bonds could fall further.
Still, China likely will move cautiously, because it has a lot at stake: Any large jump in the yuan's value against the dollar would reduce the competitiveness of China's exports and slash the value of its vast dollar-denominated reserves.
"It's not good for Treasurys, but it's not all that negative because it's going to be a gradualistic approach," said Gerald Lucas, head of Treasury and agency strategy at Banc of America Securities in New York. "We've all known this was coming, the only wild card is that they're going to a basket."
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