There are currently three key variables that dominate market conversation; the direction of US bond yields, oil prices, and the renminbi.
Thanks to the latest bout of jawboning from Steven Mnuchin, US Treasury secretary, the renminbi tops the list on Wednesday as the currency nears a line in the sand at Rmb7 to the US dollar.
Sino-US tension has broader ramifications as we are seeing from Wednesday’s savage tech-led sell-off in US equities (see Quick Hits below for more on that). In the meantime, please bear with me as I focus on China and its currency dilemma as the US applies the pressure.
China’s currency has not depreciated past Rmb7 since 2008. A run towards that level in August swiftly reversed when the People’s Bank of China via its daily fix succeeded in pulling the currency back towards Rmb6.8 by the end of that month. The Rmb7 level was also defended in 2017, so tolerating a much weaker currency from here would represent a big market shock and a profound reversal from Beijing.
The thinking in market circles behind China tolerating further weakness in the renminbi is that it would help offset US tariffs and boost the domestic economy. Such an approach is dangerous territory for China, and in turn, global markets. There are plenty of reasons to think China will hold the line near Rmb7, rather than risk intensifying an already fraught political and commercial relationship with the US.
China is definitely in a tight corner at the moment, reflecting its crackdown on excessive lending, particularly in its shadow financial sector — an action that has sent domestic stocks into a bear market as the economy has slowed. A sharp divergence in policy terms with the US (seen below via the difference between 10-year yields) also explains why the renminbi has depreciated nearly 11 per cent since March.
A substantial part of the decline in the currency reflects the dominance of the US dollar this year against all comers. In China’s defence, it’s a logical policy response to allow the currency to weaken as your economy softens. I certainly recall US economic soft patches in recent years being accompanied by bouts of dollar weakness that acted as a safety valve.
So what stops China from letting the currency weaken further?
Let’s start with the recent drop in the renminbi along with easing measures, all of which will take some time to feed through and ultimately help the economy. This raises another key point — we can expect more fiscal stimulus as additional monetary easing will only intensify the pressure on the currency and in turn force China to burn more of its forex reserves (which are also near a $3tn line in the sand) to support the renminbi. That’s the kind of nasty spiral Beijing really doesn’t need at the moment as it could spur capital flight.
I had a very interesting chat with Alan Ruskin at Deutsche Bank on Wednesday and I think he nails it with his observation that maintaining a sub Rmb7 is “only sustainable if China follows the US policy mix with a large fiscal stimulus”.
Now we need to see what China can deliver on the fiscal score, but there are other reasons to think further currency weakness is contained.
Earlier this year China stressed currency stability as a key policy aim. That’s not hard to fathom given the ever present worries over capital flight. In a world where the US is deploying tariffs, China needs to maintain other trading relationships, especially closer to home. Tolerating further renminbi depreciation will only intensify the pressure on many Asian currencies, already under the cosh from a stronger US dollar.
Neil Mellor at BNY Mellon notes that a weaker renminbi would spark “immediate implications for emerging markets given the importance of matching the ‘China benchmark’.”
He adds: “The fact that one-month implied volatility has risen sharply across east Asian currencies in recent sessions suggests that investors are to some extent prepared. But what cannot be appreciated are the ‘second round’ effects on domestic economic and financial stability, on stability in the emerging sphere (and beyond) and on China’s international relations. There is no dramatisation in suggesting that whatever Beijing does, its ramifications will be felt far and wide.”
Another key reason for encouraging currency stability is that China is making slow and steady steps towards entering global financial markets. As more money flows into China from foreign investors, Beijing can ill-afford a sudden depreciation in the currency that scars foreign investors, especially as more global buying of their domestic bonds allows Beijing to fund fiscal expansion.
This year has seen the inclusion of leading A shares in the MSCI Emerging Market index, while substantial foreign flows into bonds helps explain in part why Chinese government bond yields have fallen this year.
I suspect that it may well be the determination of Beijing to focus on its growing global role and the need for credibility that stops the renminbi from weakening dramatically from here. Yes, we may see some slippage around Rmb7 that reflects US-Sino policy divergence, but bottom line: selling the renminbi from here is no slam dunk trade.
Quick Hits — What’s on the market radar
Tech momentum heads south in a big way — The relief yesterday was fleeting and tech has resumed the wrong kind of leadership, slamming the broad market lower. I focused on the why higher bond yields threaten the sector yesterday. Aside from that knocking growth stocks, Sino-US trade tension has registered acutely with semiconductor stocks, which sit at the coalface of the global supply chain along with carmakers. The Sox (aka the Philadelphia Semiconductor index) plunged 4.5 per cent on Wednesday and has decisively broken below its 200-day moving average, a key measure of momentum that has held since March 2016. The Sox has hoisted a huge red flag for tech and if we look at the Faangs and Nasdaq, the message is getting through. Wednesday’s market rout on Wall Street is the clearest sign yet that investors are getting very nervous about Sino-US relations.
Global equities feel the burn — The FTSE All-World index excluding the US has on Wednesday fallen to a level last seen in July 2017 and is off nearly 9.5 per cent for this year. Nope, no tailwind of a rotation out of US equities yet.
The pound has buyers — Rising hopes that the UK and EU are fleshing out their divorce pushed the pound beyond $1.32 on Wednesday and to its best level versus the euro since June. The yield on 10-year Gilts has climbed towards 1.75 per cent, a level last visited in early 2016. The bond market expects a lot less austerity and more borrowing next year.
Who wants to own Treasury debt? — Wednesday’s auction of $23bn in 10-year notes was marked by a modest drop in demand from investors. This suggests that the rise in yields is not particularly tempting. All eyes on Thursday’s US Consumer Price Index print for September, which is then followed by a 30-year bond sale.