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What we have seen today is confirmation that the market is going to play a much greater role in the future trend of the Chinese currency. This will worry some, especially given that the CNY is 10% overvalued on many longer-term metrics. The People’s Bank of China (PBoC) could look to use its FX reserves again to stabilise the spot market, but the fact that today’s CNY ‘fix’ was set at a premium to yesterday’s closing spot price is absolutely key here. It highlights that the market is going to be more heavily involved, and while this is a move designed to reach out to the International Monetary Fund (IMF) and its SDR review, if you are a business exporting to China then you are watching this development with huge interest right now.
If the market pushes up the spot market, then the PBoC will look to increase the midpoint of USD/CNY, or the ‘fix’, and the trend will be for CNY weakness. Judging by the fact that the spot USD/CNY is now CNY6.4257, then it is likely we will see more fireworks tomorrow at 11:15am AEST.
Asia is clearly reacting in a negative fashion, as expected when there are many questions and very little certainty. Australian businesses exporting to mainland China have seen the price of goods up (in AUD terms) around 1% on the week - this is even more pronounced if the product you export is priced in USD. The reaction in Australia’s miners has been significant with the ASX sub-sector down 3.1%, while energy has also been hit. 1% doesn’t sound like a lot, but if CNY continues to weaken, then how will this impact Chinese investment abroad? Will Australian property face a wave of capital if Chinese residents holding CNY feel that the end investment is appreciating at a fast rate? Buy sooner would be the mindset.
Commodities have been sold off heavily today - especially nickel, which looks horrible on the daily chart. Again, the idea that king USD is in play is promoting a deflationary move across the capital markets. Any currency where the central bank has an easing bias, or could potentially counteract the CNY weakness with easier monetary policy and the potential for China to become just that little bit more competitive, is being sold today. Emerging market currencies look vulnerable, especially those of Taiwan, Singapore and Indonesia. The AUD has been sold off by a further 100 pips or so on the idea of funds using it as a proxy for China. That will happen when 35% of your total exports have just become a little bit more expensive.
Australia in general has had a huge amount of event risk to deal with. Earnings has rolled and on the whole, the theme of companies with lofty valuations missing the elevated mark has continued (CSL). The bears will be enthused by the fact the ASX 200 has closed below the 2012 uptrend and that is a big development locally.
The trade today has been to increase US fixed income exposure, with two-year yields continuing to re-price September Fed expectations. The implied probability of a September hike has dropped to a 40% probability, down some 14 percentage points in two days! The US yield curve continues to flatten; however, unlike earlier in the week where the front end held in, we are staring at a more aggressive bid at the long end. Earlier in the week, I had looked at being short on 3-month Eurodollar futures on the idea that the Federal Reserve would start normalising policy in September, but I have exited that trade for a small loss. Ultimately, traders will ask whether this move in CNY price devaluation really will cause the Fed to leave its zero-interest policy in place.
Looking at five-year US inflation expectations (I’ve looked at bond market pricing through the so-called ‘breakeven’ rate), we can see this has ticked down a touch today to 1.29%. So the bond market is saying the US economy will average inflation of just 1.29% over a five-year period! The question that immediately springs to mind, utilising the recent speech by Fed member Dennis Lockhart: is it still ‘appropriate’ for the Fed to move in September? Would a further devaluation lead to a ‘significant deterioration’ in economic momentum? If you feel ‘no’, then there is good downside in 3-month Eurodollar futures (September contract).
European equities are also going to feed off today’s negativity, and another day of weakness is on the cards. The DAX is likely to be at the centre of the selling given the auto sectors leverage to Chinese consumers, as well as German - being such a big trading partner with China. One might look at being short DAX, long Italian MIB, given the relative exposure differential.