See important Research Disclaimer.
The financial markets are no different, and in this world of global communications, the attacks come from all and any directions. Often, our superheroes come in the form of central banks and governments. Equally as often, they can also be the villains, at least in some eyes.
China’s surprise yuan devaluation was the trigger for the ‘crisis’ this week. While there are some whom are dismayed at the PBOC’s move, decrying it as the beginning of a competitive devaluation exercise of the world, there are others who feel the intention of the action is to move in the right direction.
IMF welcomed PBOC’s change to the daily reference rate mechanism as the adjustment should allow market forces a greater say in determining the exchange rate. This is important because a more market-determined exchange rate would facilitate SDR operations when yuan is included in the SDR currency basket. Probably as a way to manage expectations, the IMF added that the latest PBOC move has no direct implications for its consideration on whether to include CNY in its SDR basket.
Nonetheless, the move had a ripple effect across the world. Investors were uncertain about the impact of a weaker yuan, or rather the consequences of such a move on market psyche. This uncertainty played out in a flight to safety. Equities were sold off and bonds were bought. However, the subsequent increases in the USD/CNY midpoint fixing lent credibility to the theory that China is going to deliberately devalue their currency to gain a competitive advantage.
The penchant for the market to react to these headlines and initial assessments typically leads to outsized knee-jerk market moves, which would usually subside quickly after deeper investigations. The new daily reference rate mechanism means that if the market close for USD/CNY was higher than the day’s fixing, the following day should see a higher fixing. The self-feed cycle then continues until the demand-supply equilibrium exerts its authority.
At this point, the Chinese central bank is not allowing market volatility to its own device, and like any good central bank worth its weight in salt, PBOC deployed verbal intervention to calm sentiments, saying that it stands ready to act if there are excessive fluctuations. This appeared to work.
Market sentiments are noticeably more composed today. The lower USD/CNY midpoint fixing at 6.3975, against 6.4010, on Thursday which also helped. What is more interesting was the fact that implied probability for a September Fed hike jumped back to 50%, reflecting market perception that the Chinese move is no longer a huge consideration in the US monetary policy. Their expectations were also supported by a decent US July retail sales report.
As such, we could see Asian markets starting on a more risky tune. However, there may not be any large positioning ahead of the weekend and any gains in the risk asset markets are expected to be modest. Commodities should continue to stay under pressure, with crude likely to clock their seventh weekly losses. Brent remained capped below $50, while WTI is weighed below March lows, trading at around $42. The earlier IEA assessment that the supply glut situation would be extended beyond 2015 contributed to the pessimistic outlook for energy.