With China unexpectedly announcing the revaluation of the yuan (RMB) last Thursday, MBS analysts expect the People's Bank of China to buy fewer U.S. dollar fixed-income assets, including mortgage-backed securities. The lower demand should not be drastic, however, but a gradual dip in U.S. investments is expected over time.
Bear Stearns Senior Economist Conrad DeQuadros said that China's change in currency valuation does not imply an automatic reallocation of Chinese reserve assets away from the U.S. dollar. Over time, the market will likely push the RMB to a higher level against the dollar but the Chinese government is seen intervening to keep currency fluctuations range bound.
"The important thing to realize short-term is that China has been setting up for this move for months," Alec Crawford, managing director in passthrough trading at RBS Greenwich Capital Markets. "They have been buying fewer U.S. dollar assets and buying euros versus U.S. dollars in the foreign exchange markets."
Crawford expects that China will remain a purchaser of U.S. bonds going forward as U.S. yields are still more attractive compared to either Europe's or Japan's. This potential lessening in U.S. bond purchases will be accompanied by further asset diversification. With China already buying U.S. Treasurys, U.S. agency debt, MBS and ABS, Crawford expects to see China start buying hybrid ARMs. "They are becoming more sophisticated investors," he said.
Crawford added that assets driven very rich by Asian buying will likely cheapen, thus he put out a longer-term underweight recommendation on lower coupon mortgages, specifically FNMA 5s, and GNMA 5.5s. Crawford recommends a neutral bias on the MBS basis, and that investors write covered calls on 10-year swaps or U.S. Treasurys to earn carry. Crawford added that yield curve steepener trades make sense at this juncture.
Art Frank, head of mortgage research at Nomura Securities, said the biggest risk to MBS underperformance is a bull flattening, which appears less likely now with the yield curve steepening and rates rising. As of last Thursday, 2s to 10s steepened four basis points with the two-year Treasury yield up six basis points and the 10-year Treasury yield increasing 10 basis points.
Although the Chinese revaluation could result in fear of a weaker dollar, and reduce foreign buying of U.S. bonds, including MBS, a steeper yield curve could partially offset this by bringing in more buyers, including banks and CMO underwriters, Frank said. He also expects that U.S. purchases by the Chinese Central Bank would not diminish much for as long as China still generates trade surpluses that need to be invested in high-quality assets. There is a concern in the market that private Asian investors might be "less positive about the U.S. dollar and might, as a result, lessen their investments in MBS," Frank stated.
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