China has suspended its stock market circuit breakers but does this mean the currency devaluation will stop? And does that mean it's safe to buy stocks again?
The short answer is no. The assumption that China is choosing to devalue its currency is wrong. China is being forced to devalue by capital flight. As Reuters reports, Chinese foreign-exchange reserves have fallen by a record number in 2015 and it appears the outflows are accelerating.
As the Chinese economy rapidly expanded, hot money flowed into the country, mostly in the form of U.S. dollars. The Chinese central bank was more than happy to take these U.S. dollars in exchange for yuan and then it bought U.S. Treasurys. This symbiotic relationship allowed China investment to expand while the United States benefited from a ready, willing and able creditor. In short, the Chinese economic expansion financed the U.S. budget deficits. That process is now going into reverse.
We know the Chinese economy is slowing, perhaps dramatically. However, whether the Chinese can engineer a soft or a hard landing is inconsequential to investors. If investment returns in China have diminished, then it is time to move money out of the country. This is exactly what is occurring and is the reason for the yuan weakness. While a weaker currency certainly benefits Chinese exporters, it is unlikely that the central planners would want a weaker currency at the expense of their own stock market.
The Chinese currency is weakening considerably not because the central planners want that to happen, but rather because money is fleeing the country. The implication is that China does not have control of its currency and must sell U.S. dollars (the bulk of its reserves) to keep the currency from weakening even more.
This selling of dollars has been occurring all year long, but what investors need to know is that the U.S. dollars are held in U.S. Treasurys. This means that China is selling U.S. Treasurys to get the U.S. dollars its needs to defend its currency. The bulk of China's U.S. Treasury holdings are in the 5-year U.S. Treasury note. We can see the effect in the 5-year yield, which has barely moved over the last several years (especially when compared to the 30-year yield).
Notice that 30-year yields (red) have dropped from 3.9 percent to below 3 percent; however the yield on the 5-year note has remained elevated. This divergence in yields is evidence that China is selling 5-year notes. We can also see in the U.S. Treasury reports that Chinese holdings of U.S. bonds and notes have been declining. This is further evidence that the money flows of the last few years have shifted into reverse.
This reversal in money flows is having an outsized effect on the financial markets. The U.S. Treasury yield curve is flattening, which is often a sign of impending recession. The flattening of the yield curve could be exacerbated by Chinese sales of 5-year Treasury notes. In the extreme case, if China continues to defend its currency, it could cause the U.S. yield curve to invert as it sells 5-year notes.
In this environment, gold is king. Despite a decline in fiat currency reserves, China's holdings of gold have increased to $60.19 billion in December as compared to $59.52 billion in November. Moreover, wealthy Chinese citizens who are looking to preserve wealth while the yuan devalues will almost certainly look to gold as a safe haven.
The tectonic plates of the global financial system are shifting. Investors would be wise to be extremely cautious and conservative during this earthquake.
Brian Kelly is founder and managing member of Brian Kelly Capital LLC, a global macro investment firm catering to high net worth individuals, family offices and institutions. He is also the creator of the BKCM Indexes, benchmarks for multi-asset money managers. He's also the author of the upcoming book, "The Bitcoin Big Bang: How Alternative Currencies Are About to Change the World." Kelly, a CNBC contributor, often appears on "Fast Money." Follow him on Twitter @BKBrianKelly.
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