China said it would no longer keep its currency, the yuan, pegged to the dollar. Some credible sources say it doesn’t matter, but it does matter because it could cause U.S. interest rates to rise. It works like this: up to now, China has kept their currency weak relative to the dollar. This makes Chinese products cheap in the U.S. so we buy their goods, and our dollar-denominated purchases help stockpile China’s foreign exchange reserves. China then reinvests those U.S. dollars back into U.S. bonds, mainly Treasuries, which pushes our rates down. But letting the yuan rise could make Chinese products more expensive in the U.S. This would reverse the cycle. Fewer U.S. purchases of Chinese goods mean less dollar reserves for China, which means less U.S. bond purchases by China, which means higher rates for the U.S.
This is what relaxing the yuan’s peg to the dollar means in simple terms. The rest is actual market dynamics. This is why the upward rate impact is debatable. But we’ll see how it goes from here, starting this week when we have $108b in Treasury bonds being auctioned—just like we do every other week as the U.S. continues to issue more and more debt to fund our own economic stimulus. Soon we’ll see if China’s new currency policy will impact their ability to be a large buyer of our debt.