Here’s The Most Important Question For Risk: Whither The Yuan, My Friends?

Sometimes it seems like no one gets it when it comes to the Chinese yuan, which is really too bad because in many ways, what happens to the renminbi determines the direction for risk assets.

Last August, the market was abuzz with news that Beijing had decided to let the market play a more active role in determining the exchange rate for the RMB. It was an absurdly transparent effort to boost the export-driven economy with a competitive devaluation and to pacify the IMF whose favor the PBoC was desperate to curry amid China’s bid to land the yuan in the SDR basket.

What seemed to confuse investors was the apparent contradiction between the desire to devalue and the liquidation of hundreds of billions in FX reserves to prop up the currency.

What had happened, of course, was that China had gambled and lost. Here’s the thing: when you dictate the daily fix to control the spot price, you’ve got a lot of control. That is, you can set things where you want them to be and if something bad happens one day it doesn’t really matter because you can just “correct” it the next day by moving the fix back to where you want it.

Speculators then, effectively have to start from square one each and every day.

But when you ostensibly move to allow the spot to have a role in dictating the fix (i.e. when you incorporate the previous day’s trade into your calculations of how the following day’s fix comes in), well, then you have a problem if things start moving too quickly in the “right” direction. I say the “right” direction because China wants to devalue. It’s the only thing that will save their economy. But they don’t want the yuan to depreciate too quickly. That drives capital flight and could potentially create the conditions that would ultimately lead to a crisis. So what do you do? Well, you implement a “sort of” devaluation. You set the fix sharply lower, tell everyone it’s now all about the spot, and then in a pinch (which turned out to be every single day in late August) you burn your reserves to manipulate that spot.

It’s another one of those market dynamics that seems complicated until you just think about it for a second. And yet it still confuses everyone. Here’s WSJ for instance: “[the yuan is] back under tight government control.”

When was the yuan not under “tight government control?” Look at the size of the PBoC’s forwards book as of the end of March. There’s no other way to interpret that than outright intervention.

Make no mistake, this isn’t some kind of esoteric topic that can be ignored by anyone who isn’t a currency trader. In fact, the fate of the yuan is probably the most important factor for the Fed in determining when (or perhaps “if” is the better term) to raise rates.

On Tuesday for instance, the PBoC set the yuan fix at the weakest level in more than five years. The bottom line: from a competitiveness perspective, Beijing cannot afford to have the yuan dragged perpetually higher by the dollar peg but at the same time, the Politburo can’t afford to simply allow the RMB to float because that would invariably trigger massive capital outflows.

Thanks to the now infamous “Shanghai Accord,” things have stabilized over the past several months. The Goldilocks scenario for China has played out: the yuan has remained stable against the dollar and fallen against other currencies.

But now, a hawkish Fed is set to shake things up and how China reacts will go a long way towards determining what the appetite for risk is going forward. What’s interesting is that no one really seems to have a good read on what’s coming - it’s just a guessing game. But one thing everyone agrees on is that China’s response - as conveyed through daily yuan fixings - matters.

A lot.

"If we take the China response in the currency off the table, the risk of a 15 percent correction drops markedly," Jefferies Chief Market Strategist David Zervos (who once donned an “I love QE” hat on national television) told Bloomberg on Tuesday. "[The] market is repricing that today."

Bloomberg goes on to quote Citi’s Steven Englander who is out this week with an insightful if somewhat confused FX note. “Long USD, short EM in a risk on environment is not what we are thinking of when we talk about divergence,” Englander writes. Well, no. Obviously not. Why would anyone be long USD and short EM in a risk-on environment? In other words: thanks Mr. Englander, I certainly hope that’s not what you were thinking.

But sarcasm aside, Steve is actually an excellent strategist. Or at least I have always enjoyed his notes. He does make some great points. What I find particularly enlightening is this bit:

“China’s stabilization of currencies may reflect its own interests rather than altruism. In Q3 of last year when CNY was depreciating against USD, it was appreciating against other Asian currencies, as FX market instability led them to depreciate even faster. In Q4 the depreciation was about the same. Insofar as China was trying to regional competitiveness against regional competitors it is hard to argue that the outcomes were a brilliant success. It gained more competitiveness ground during risk on periods, when EM ex China appreciation far exceeded any CNY move. Similarly Figure 4 highlights the CNH-CNY premium and the behavior of the Shanghai composite over the summer and in late 2015/early 2016. Recent moves have been much more muted. There is no guarantee of success but acting to stabilize asset markets may be seen as worth a try since they gain little from adding asset market volatility in an already fragile economic and financial market environment.”

If you think about it, that’s really interesting. What Englander is saying is that China seems to have underestimated how important yuan stability is to risk assets. And in doing so, they inadvertently shot themselves in the foot. After all, EM is synonymous with risk and China is synonymous with EM. They tried to get a leg up in the currency wars, but they failed to understand that other Asia ex-Japan FX crosses would get hit worse than the yuan by virtue of the still intact USD peg.

Here’s the thing: this has become the issue for markets going forward. It’s not about whether the Fed raises rates. It’s about what happens to the yuan if the Fed moves.

No one knows the answer.

Not even China.
And that, my friends, is scary.

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