Markets Ease Exaggeration, Dollar and Stocks Recover

  • Investors over-reacted to what is ultimately a relatively small move in the yuan
  • The engineered depreciation is nearly complete, but the yuan could still decline
  • Many investors who were already primed to think in currency war terms feared a new front had opened
  • The yuan’s modest pullback or the short-term volatility in the capital markets will not impact the Fed’s decision in a little more than a month’s time
  • Prime Minister Abe has called a special cabinet meeting tomorrow, but details are not available, so markets have begun to speculate on the topic
  • On the EM side, we note that markets have welcomed the change the government cabinet reshuffle in Indonesia with a 2.3% rally in the Jakarta comp, and that this could be a decisive day for Turkey
  • Agricultural prices are clawing back some of their huge losses yesterday

Price action: The dollar is mixed on the day. The euro is giving back some of yesterday’s gains, now at $1.1120. Sterling is a bit weaker at $1.5620. The krona is easily the strongest currency today, with the dollar falling to SEK 8.51, the lows for the month, following a higher inflation print. The dollar has bounced back against the yen, now at ¥124.50. In the EM space, KRW is outperforming, rebounding 1.5% from yesterday’s 1% losses. Most other EM Asian currencies are also higher, while INR and TRY are underperforming. Equity markets are broadly higher. Asian indices were mostly higher with Shanghai Comp up 1.7%, the Nikkei gaining 1% and Indonesia outperforming, up 2.3% (see below). EuroStoxx is up 1.6% and US futures are up fractionally. Global sovereign debt yields are a few basis points higher, notably UK 10-year gilts, up 5bp.

  • Investors over-reacted to what is ultimately a relatively small move in the yuan.  The yuan is off about 3%, with the offshore yuan (CNH) off a bit more.  It may help some small companies with narrow profit-margins, but on the whole, the move is far too small to change China’s export competitiveness.  The key to China’s exports is stronger world growth, which is why exports to the US have risen but not to Europe or Japan.
  • Still, the move caught the market off-guard.  After seemingly re-pegging the yuan to the dollar, it reset the yuan to the lower end of its 2% band and announced a new mechanism that seems still to be largely a “black box”, in the sense of lacking much transparency.  Markets became unsettled.  The main concern was not what investors knew, but what they did not know. The unknowns were two-fold:  How much devaluation was China seeking and how would others respond.
  • Through intervention to support the yuan, yesterday and some talk of a similar operation today, and guidance by PBOC officials, the engineered depreciation is nearly complete.  However, China has introduced a new mechanism that gives market forces greater sway.  Given the slowing of the Chinese economy and the prospects of Fed tightening, the yuan, like other currencies in those circumstances should decline.
  • Many investors who were already primed to think in currency war terms feared a new front had opened.  Yet, outside of some in the media and a few analysts, few took the bait.  We note that the IMF and US Treasury welcomed the move, provided that it was implemented as the declaratory policy implied.  Yesterday, Dudley, President of the NY Fed recognized that given macro situation in China, it would “not be inappropriate” for the yuan to weaken.    Moreover the fact that the South Korean and Philippines central banks, both of which had meetings today, did not respond to the yuan’s depreciation, also suggests the currency war meme has once again been exaggerated.
  • Nor does the yuan’s modest pullback or the short-term volatility in the capital markets impact the Fed’s decision in a little more than a month’s time.   It has been a light week for US economic data to help investors anchor views, and today’s retail sales report will likely be helpful.  The consensus expects a 0.6% increase in July retail sales after the 0.3% fall in June.  The GDP component (excluding auto, gasoline and building materials) is expected to rise 0.5% after declining 0.1% in June.  The risk, we suspect, is on the upside, though acknowledge that the impact of Amazon’s Prime Day and the competitive response by other large retailers is difficult to assess.
  • The market equilibrium appeared to have begun returning in the North American afternoon yesterday, and there has been further follow-through today as the pendulum continues to correct the over-shoot.   The US 10-year yield is 10 bp above yesterday’s low print.   The two-year yield is six basis points higher.  The S&P 500 gapped lower, below its 200-day moving average, but recovered fully to close fractionally higher on the day.  Asian and European equities have also recovered.  The dollar is also recovering.  It is higher against all the major currencies, save sterling and the Swedish krona.
  • The krona is easily the strongest currency today, rising almost 1% against the dollar and 1.4% against the euro.  The driver was the higher than expected inflation reading.  The July CPI was unchanged, whereas the consensus was for a 0.3% fall.  This saw the year-over-year rate rise to -0.1% from -0.4%.  The underlying rate, which used fixed mortgage interest rates, but does not exclude food or energy as core rates typically do, rose to 0.9% from 0.6%.  The consensus expected an unchanged rate.  The Riksbank meets on September 3, and ideas that it would expand its bond buying program or cut rates deeper into negative territory are being re-thought.
  • Since the end of June, the euro appreciated nearly 5% against the krona, from below SEK9.20 to almost SEK9.63 at the start of this week.  Today’s move has seen the euro surrender 38% of those gains (~SEK4.46), which also corresponds to the 20-day moving average.  A break of this area would target SEK9.40, and possibly SEK9.35.
  • The dollar briefly dipped below JPY124 yesterday but recovered with US yields and stocks in the second half of the session.   Although Japan revised up June industrial output to 1.1% from 0.8%, the market paid more attention to the unexpectedly large drop in machine orders, which are seen as a lead indicator for capex.  Machinery orders fell 7.9% in June.  The consensus was for a 4.8% decline.  Early Monday in Tokyo, the first estimate of Q2 GDP will be reported.  The consensus expects a 0.5% decline quarter-over-quarter.
  • First though, Prime Minister Abe has called a special cabinet meeting tomorrow.  Details are not available, which means speculation has the upper hand.  Three potential topics are being suggested:  WWII commemoration, re-starting of a nuclear plant this week, and a response to Chinese developments.   If the issue is indeed one of these three, we are more inclined to the first.  The second likely has already been discussed.  The third is part of the previous exaggeration.
  • Lastly, we note that Greece reported Q2 GDP at 0.8%.  The consensus was for a 0.5% contraction.   A healthy skepticism greeted the announcement.  The focus on Greece is two-fold.  First, later today Greece’s parliament is expected to vote on the two measures to endorse the third aid package.  Second, Germany is still balking.  Remember 60 MPs in Merkel’s CDU/CSU did not want to enter into such talks in the first place.  Apparently with the summer holidays, the cajoling, arm-twisting, and deal making, to ensure a favorable outcome is more difficult.  A bridge loan option is still being pushed, it appears.
  • The euro peaked yesterday near $1.1215, which is within a whisker of the July 10 high.  Some will see this as a potential (bearish) double top.  Even so, it would only re-emphasize the significance of the $1.08 support.  Since the US jobs data, the euro has rallied from roughly $1.0855 to $1.1215.  Assuming that move is complete, the first retracement is near $1.1080.  There are other technical targets in the $1.1030-60 area.
  • Markets have welcomed the change the government cabinet reshuffle in Indonesia with a 2.3% rally in the Jakarta comp. We see this as an important step in the right direction President Widodo has changed around his economic team yesterday and promised that a new economic plan is forthcoming to revive the economy. The new economic minister is former central governor Nasution. The Jakarta comp has been the worst performing index in Asia so far this year and the rupiah is down nearly 10% over the same period.
  • Turkey is facing a knife edge moment. As we highlighted in a report today, many observers are believe that a coalition government could be announced or hinted at by Friday. That would break the stalemate in Turkish politics and avoid early elections. Markets are clearly trading off this news, with Turkish assets outperforming earlier in the week  despite weak risk appetite globally and the intensification of the conflict with the Kurds.
  • Elsewhere in the EM space, Malaysia’s GDP came in on the strong side, while the meetings by the Korean and Philippine central banks were uneventful, both keeping their policy rates unchanged as expected. Malaysia 2Q GDP rose 4.9% y/y vs. 4.5% expected. Still, it’s a notable slowdown from the 5.6% pace growth in 1Q. Most sectors slowed.  Manufacturing rose 4.2% y/y, the lowest for 2 years and construction rose 5.6% y/y, the lowest since 3Q 2011. Net exports continue to decrease, dropping 10.5% y/y in 2Q. So the weak MYR has not yet worked to offset lower commodity prices and weak external demands for Malaysian products. Malaysian central bank noted its economy was expected to remain on steady growth path but the economy depends on domestic demands in particular private investments. The central bank is likely to keep the status quo to support MYR.
  • Agricultural prices are clawing back some of their huge losses yesterday. Corn and soybean futures are up around 1% today after falling 5% and 6.3% yesterday, respectively. The driver for the price action was a very bearish report by the USDA. The report stated that corn production for the year could be the second highest yield and third largest production on record for the US. Meanwhile, the area planted for soybeans is breaking new records. Other commodity prices are mixed on the day, with precious metals down while energy and industrial metals are rising. Of note, iron ore futures are up 3.18% in the Dalian Commodity Exchange, extending a 24% rally since its lows in early July.