Although the market certainly pays attention to what happens in China, I don’t think most strategists give enough credit to how much the Chinese economic and financial conditions affect the global economy and markets. The world’s second biggest economy has an increasingly disproportionate affect on the day to day swings in the market.

Last year China recognized that their real estate market was rising too fast and that their economy was dangerously unbalanced. They relied way too much on exports and infrastructure spending. The Chinese leadership set about trying to slow down the real estate speculation and encourage more domestic internal economic activity.

They did this by allowing rates and their currency to rise. CNY (in white) and Chinese 2 year yield (in yellow)</a> </div>

The Chinese currency is usually expressed as the reciprocal of what I charted, but I thought it was easier to see if I showed it so that a higher Chinese currency went higher instead of lower.

The Chinese government allowed both their currency and their interest rates to rise for most of 2013. This had a dramatic effect on the Chinese economy. It did indeed slow down Chinese real estate speculation, but it also had negative effects on many other parts of the economy. The higher interest rates and more expensive currency caused many of the bad loans to become stressed. This translated into banking system worries. The spread between the risk free government rate and the banking system swap spread blew out to record highs. 2 year swap spreads</a> </div>

Towards the end of the 2013 there were many reports worrying about the stability of the Chinese banking system. There was story after story about all the bad debts and how it was going to all come to crashing halt.

Realizing that they had probably squeezed hard enough, the Chinese government loosened their grip at the turn of the year. Most of 2014 has seen lower rates and a weakening currency.

This has finally had the expected result in kickstarting the moribund Chinese economy. This morning the HSBC Chinese PMI was announced and for the first time in a year the survey has topped expectations. PMI – exceeding expectations for the first time in a while</a> </div>

All good news, right? Not so fast…

Let’s think back to the reasons that China was so desperate to rebalance their economy in the first place. The old Chinese economic model was to keep their currency low, which encouraged economic exports. But that meant that there would be demand for their currency which if it was allowed to rise, would hurt exports – so the Chinese government would sell currency. When they sold the Chinese currency, they would be buying the importing country’s currency (mostly the US dollar) and would need to do something with the ever growing foreign exchange balance. The Chinese government would mostly buy the other country’s bonds, thus lowering rates. The lower rates would have a stimulative effect on that country’s economy, which encouraged more consumption of Chinese exported goods. This process created a dangerous feedback loop that encouraged more and more debt with increasingly large foreign exchange balances. It is obviously a lot more complicated than that, but that is a pretty decent simple description of the problem.

Now let’s think about what has happened in China over the last six months. Instead of continuing on with their painful restructuring, they have reverted back to the old model of using a weaker currency to encourage export growth. In doing so they have indeed stopped their economic slide, but they have just put off their day of reckoning.

And more importantly, they have gone back to creating even larger imbalances. Many market watchers (me included) were surprised by the dramatic bond rally of the past quarter. But it is actually pretty easily explained. According to the Wall Street Journal:

The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago, data released Wednesday show. The world’s most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014, according to the U.S. government data. The buying has been fuelled by China’s efforts to lift its export-driven economy by weakening its currency, the yuan, against the dollar, market analysts said, a strategy that encompasses hefty purchases of U.S. assets. 10 Year Yield (white line) CNY (inverted yellow line)</a> </div>

There is obviously much more going on in the bond market than just the Chinese buying, but there is no doubt that their return has caused rates to decline.

The Chinese buying has pushed down the risk free rate and encouraged other investors out the risk curve. The Chinese policy change is one of the contributing factors for the recent stock market rally. And that is assuming that the Chinese themselves haven’t decided to also put some of their foreign exchange reserves directly into the stock market. It wouldn’t surprise me at all if we find out years later that the Chinese government was one of the big buyers of US stock market futures.

What does this all mean? Where do we go from here?

I don’t know because I am not sure what the Chinese government is going to do. How long will they allow their currency to stay weak and their interest rates low? Will they return to the trying to rebalance their economy now that the slow down has eased up?

Whatever way they head, make sure you keep your eye on their policy decisions because it is affecting US markets much more than most market watchers realize.

If I had to bet, I would guess that the Chinese are committed to rebalancing their economy and that this recent return to the old economic model is temporary. They are simply trying to navigate a soft landing. I would expect to see the Chinese currency to start to rise once again, and this will ultimately have the effect of sending US bonds lower as well.