China Surprises, Mini-Devaluation, USD Mostly Firmer

  • Chinese officials surprised the market by instituting a mini-devaluation of the yuan and changing how it sets the fix
  • Today’s depreciation is unlikely to have a perceptible impact on the competitiveness of China’s exports
  • The move does not appear to be panicking or simply a move out of weakness
  • The depreciation of the yuan sparked a retreat in commodity prices
  • Some attributed yesterday’s dollar retreat to Fed’s Vice Chairman Fischer emphasizing low inflation, but we think this is largely stylistic
  • Despite the increase in violence in Turkey (7 PKK militants killed today), the TRY is the clear outperformer

Price action:  The dollar is broadly stronger in the wake of the surprise CNY devaluation.  In the majors, the dollar bloc is underperforming while the euro is outperforming and is flat on the day at just above $1.10.  Sterling is trading just below $1.56, while dollar/yen is trading just below 125.  EM currencies are broadly, with CNY underperforming and dragging KRW, SGD, and TWD lower as well.  TRY and the CEE currencies are outperforming.  MSCI Asia Pacific was down 1%, with the Nikkei down 0.4%.  The Shanghai Composite was flat, while the Shenzhen Composite rose 0.4%.  Euro Stoxx 600 is down 1% near midday, while Greek stocks are rising for the fourth straight day, up 2%.  S&P futures are pointing to a lower open.  The US 10-year yield is down 7 bp at 2.16%, while European bond markets are mostly firmer too.  Commodity prices are mostly lower.

  • Chinese officials surprised the market by instituting a mini-devaluation of the yuan.  The 1.9% move was signalled by announcing the highest dollar fix in two years.  Officials indicated that this was a one-off move in response to the appreciation of the real exchange rate.  At the same time, it injected CNY50 bln through a seven-day repo operation, which offset part of the CNY85 bln of maturing repo and bills.
  • The PBOC also announced a change in the setting of the central reference rate (the fix).  Going forward, it will be more influenced by the previous close (in Shanghai) and subsequent changes in the other currencies.  This is potentially important from an operational point of view, especially in light of the work that needs to be done to be included in the IMF’s SDR.  However, like much in China, the actual practice may deviate from what appears to be the declaratory policy.  There is a great deal of uncertainty about what happens next.
  • With the dollar appreciating against a broad range of currencies and the yuan (for all practical purposes) pegged against the greenback, of course it appreciated on a trade-weighted basis.  This move comes on the heels of weak exports and non-food prices.  There are three orders of impact that investors are contemplating.
  • First is the effect on the Chinese economy itself.  Given that the value-added in China of much of its exports is still fairly limited to 20-33%, today’s depreciation is unlikely to have a perceptible impact on the competitiveness of China’s exports.  In terms of China’s financial conditions, the devaluation is likely to be reinforced with other easing measures, like a cut in required reserves or interest rates.  The gap reported today between new yuan loans in July (CNY1.48 trln) and the aggregate financing (CNY718.8 bln) likely reflects the funds used to arrest the slide in equities.
  • Although China’s move was not telegraphed and is clearly in response to recent developments, it does not appear to be panicking or simply a move out of weakness.  It is a vote of confidence in the ability of the financial market to absorb it.  Also, it is not particularly concerned about raising the debt servicing costs of the numerous Chinese corporates who borrowed dollars.
  • The second order of effect is on commodity markets.  The depreciation of the yuan sparked a retreat in commodity prices.  Losses are not very steep but are broadly felt, through the industrial metals and energy.  Gold is about 0.8% higher.
  • The third order of effect is on the financial markets.  The dollar-bloc and emerging market currencies are bearing the brunt.  The antipodeans are off 1%.  The Australian dollar is posting an outside day, having initially risen above yesterday’s highs and then sold off below yesterday’s lows.  It held above $0.7300, well above the multi-year low set at the end of July near $0.7235, and it has threatened what had appeared to have been corrective forces.   The Canadian dollar is off half as much.  The US dollar found support just below CAD1.30.
  • The euro and sterling initially fell, but both recouped those losses to move higher, extending yesterday’s recovery in the European morning.  There was talk of leveraged accounts unwinding short euro carry positions that had been established against the yuan.  The more in the offshore non-deliverable forward market, strictly a function of supply and demand moved twice as much as spot (12-month NDF).
  • EM currencies are down sharply on the day following the move by Chinese policymakers.  The Singapore dollar is down 1.3%, with USD/SGD rising above the 1.40 level for the first time since mid-2010.  The Korean won fell 1.3% too, with USD/KRW quickly approaching 2012 highs.  TWD also lost 1.3%, as all Asian currencies were lower on the day.
  • The Mexican peso and Russian ruble are down nearly 1%, while the South African rand is down over 0.5%.
    Already, the press and observers have seized on the China move as another round in the so-called “currency wars.”  We disagree.  China officials are presenting it as allowing for a greater market role in determining the exchange rate, and we accept this at face value in light of the changes to the daily fix mechanism.  With most EM currencies sharply weaker this year, the stable yuan (and appreciating REER) stuck out like a sore thumb.  PBOC had kept fixing USD/CNY near the year’s lows, despite all signs globally that the pair should instead be moving higher.
  • We do take issue with China’s tactics, however.  A steady and gradual move higher in USD/CNY would have been less disruptive than a bigger one-off move.  We find that a one-off devaluation often leads markets to believe that another one may be delivered, sparking capital outflows and leading to a self-fulfilling prophecy.  Capital outflow is the one major risk that China needs to monitor.
  • Global bonds have rallied.  The US 10-year Treasury is off 7 bp to 2.15%.  We note that the 200-day moving average is near 2.14%.  European bond yields are off most around 5 bp, with the gilt yield off 8 bp.  News that an agreement with Greece will be ready for the Greek  parliament to vote on in time for the Eurogroup meeting on Friday has helped Greek bonds rally, with the 10-year falling back below 10%.  Greek stocks are also bucking the losses in equity markets.  Athens is up about 2%, led by financials with twice the gain.
  • Some attributed yesterday’s dollar retreat to comments by Fed’s Vice Chairman Fischer, who seemed to emphasize the low inflation rather than the recent constructive jobs data.  We think this was largely stylistic, and that Fischer did not deviate from the Phillips Curve understanding that absorption of slack in the labor market will lift inflation over time.  He also recognized that most of what is dampening inflation is of a transitory nature.  We note in this context that the September Fed funds futures were unchanged on the session, and the two-year note yield was 0.5 bp higher despite the gains in the equity market.
  • Despite the increase in violence in Turkey (7 PKK militants killed today), the TRY is the clear outperformer. The currency is up nearly 0.5% during the London morning while most other of its EM peers are in negative territory. This may be in part due to positive headlines from the leadership of the main opposition party CHP suggesting that a coalition with the ruling AKP is possible. The leader of the two parties will meet again at the end of the week.
  • Here is a quick round up of the EM data overnight. Russia’s GDP contracted by -4.6% in Q2, the largest decline in six years, and a touch more than expected.  The previous quarter saw a -2.2% GDP.  Philippines’ exports contracted just -3.3%, expected at -16% y/y.  Electronics imports, which are typically processed and re-exported, came in on the strong side, rising 9.5%.  Hungary’s July CPI came near expectations at 0.4% y/y, down from 0.6% in June.  It reports Q2 GDP Friday, and is expected to rise 3.2% y/y.  The firm growth outlook and rising inflation has led the central bank to say it was halting its easing cycle at its last meeting. Turkey’s June current account data showed a deficit of -$3.4 bln, just a bit wider than expected, and the May numbers were revised to show a $0.5 bln higher deficit. The year to date deficit is now at $22.7 bln, maintaining the gradual trend of improvement.
  • Later today, South Africa reports June manufacturing, and is expected at -0.9% y/y vs. -1.4% in May.  We still think the SARB’s last 25 bp hike was ill-advised, as the economy remains weak.  Next policy meeting is September 23, and there is a risk that it hikes again despite the soft economy. Brazil reports the first preview of IGP-M wholesale inflation, and is expected at 7.8% y/y vs. 7.0% in July.  Price pressures continue to rise, and will keep pressure on COPOM to continue tightening, even though the last statement said they were on hold.  Lastly, Mexico reports June IP, and is expected to rise 1.1% y/y vs. -0.9% in May.