Treasury yields see largest one-week rise since June

“If capital were to leave emerging economies, especially those that peg their currencies against the dollar, the natural thing to do is to sell Treasuries”, said Gene Tannuzzo, portfolio manager at Columbia Threadneedle Investments in Minneapolis.

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But a counter flow – call it “quantitative tightening” – is gathering force as China sells foreign exchange reserves to protect its economy and markets from the recent surge of capital out of the country.

U.S. Treasury bonds strengthened on Friday for a second consecutive session as rising volatility in riskier markets and a contained U.S. inflation indicator boost the appeal of haven assets.

Treasury yields rose Thursday, after the Commerce Department said that the U.S. economy grew at a faster pace in the second quarter than initially estimated.

China’s stock market ended Thursday higher, but investor enthusiasm was dampened with the realization China’s central bank has been intervening in the market just before the closing bell. The Bank of Japan is also buying large quantities of bonds.

China is by far the world’s biggest holder of FX reserves, most of which is in dollar-denominated assets like US Treasury bills and bonds.

The PBOC has sold at least $106 billion of reserve assets in the last two weeks, including Treasuries, according to an estimate from Societe Generale SA. At the end of June it had $3.69 trillion compared with around $150 billion at the turn of the millennium. US Treasury data show that China holds $1.27 trillion of US bills and bonds, but analysts agree it is substantially more than that.

One sign is how expensive the newest 10-year Treasury notes have become relative to older issues, said David Keeble, global head of interest strategy at Credit Agricole Corporate & Investment Bank in New York.

After six years of quantitative easing, prepare for quantitative tightening. The 10-year yield was up 2.2 basis points on the day to 2.188%, while the two-year yield was up 4.7 basis points to 0.731%.

It comes at a time when the Federal Reserve is contemplating allowing interest rates to rise before the end of the year.

Under the leadership of Federal Reserve Chairwoman Janet Yellen, the Fed has engaged in a “pivot,” shifting concern from stimulating job growth to worrying about inflation.

According to The Wall Street Journal, the yield on the two-year note approached a 2015 high. On Wednesday we summed the situation up as follows: “one of the catalysts for the EM outflows is the looming Fed hike which, when taken together with the above, means that if the FOMC raises rates, they will nearly surely accelerate the pressure on EM, triggering further FX reserve drawdowns (i.e. UST dumping), resulting in substantial upward pressure on yields and prompting an immediate policy reversal and perhaps even QE4″.

Under the QE bond-buying spree, the Fed’s balance sheet ballooned to a record .48 trillion accumulated since announcing the first round of QE purchases in November 2008.