As we head into the holiday weekend, why not think about China?
Actually, wait. Don’t answer that. It’s the 4th of July. Independence Day. So for US traders, that’s probably one reason not think too hard about China.
Let’s try that again: as we head into the holiday weekend, it’s important to remember that as scary as the prospect of the European Union dissolving most certainly is, the real risk to markets emanates from China. And we’re not just talking about the “hard landing” cliche here.
With regard to the EU, everyone isn’t going to just pack up and leave all at once. Here’s a snapshot of referendum risk from Deutsche Bank:
(Graphic: Deutsche Bank)
In a nutshell: there are all manner of hurdles to complete dissolution. While the ongoing refugee crisis will undoubtedly give the euroskeptics plenty of fodder for the soapbox, the reality is that we’re a long way from the whole thing falling apart entirely. Here’s how Citi puts it:
“‘Buy now, worry later’: The problem with pricing Brexit is that the risks are long-term and in the tail. With no imminent signs of contagion and the prospect of yet more monetary stimulus, a weaker growth outlook and greater political uncertainty is being dominated by a strong technical.”
Right. A “strong technical.” And we like our “technicals,” to be strong.
But one “technical” that’s not “strong” is the offshore Chinese yuan, which briefly plunged Thursday on reports China is set to weaken the currency to 6.80 by the end of the year. S&P futures got very upset. Thankfully, the PBoC stepped in and closed the onshore/offshore spread (represented by the shaded area below):
That chart represents an important dynamic. When the yuan gets too weak, too fast, it flips the risk-off switch for markets. We look to the spread between the offshore yuan (CNH) and the onshore yuan (CNY) for clues as to how much pressure the currency is under. The reason the spread matters is because the offshore yuan is more freely traded. The larger the spread, the more worried we are. As a refresher, here’s what SocGen had to say about the extent to which Brexit has served to distract the market from the “real” issue:
“Meanwhile, our attention has been diverted. China has embarked on a stealth devaluation of the renminbi. Its new trade-weighted currency basket has fallen 10% since just before its initial August 2015 devaluation (white line in chart below) and it has continued to decline since January even as the Rmb/dollar has stabilised. The Wall Street Journal has reported that this is a deliberate shift in policy link. China is now exporting its deflation, and my goodness it has a lot of deflation to export. In the Ice Age world, countries need to devalue to avoid deflation. So if sterling slumps in the aftermath of a Brexit vote there may be at least one silver lining outside the EU if the UK economy manages to avoid the quagmire of outright deflation.”
So the one positive aspect of the pound collapsing is that it helps the UK ward off the deflation China is exporting to the world via the new trade-weighted basket against which the PBoC is moving the yuan lower. Here’s a look at the weights:
(Chart: Bloomberg)
Prior to the devaluation in August, China’s export-driven economy was being choked off by the yuan’s peg to the dollar. In fact, the currency appreciated some 30% against China’s trading partners since 2010:
(Chart: Deutsche Bank)
In other words: China really needed to watch its REER (get it?). Hence the devaluation.
The problem now, however, is that no matter how hard the Fed tries to accommodate markets and keep FX volatility under control, there’s no way for the FOMC to normalize (i.e. hike) while the BoJ, the ECB, and now the BoE are all set to embark on more easing without pushing up the dollar. When the dollar rises, it effectively drags the yuan with it, which saps competitiveness from China’s decelerating economy.
Thus China attempts a high wire act wherein the PBoC guides the yuan lower against the country’s other trading partners while simultaneously keeping it relatively steady against the dollar. Everyone realizes how difficult that is, which is why the market looks for any little sign that China is about to fall off the tightrope.
So keep China in mind as we move past Brexit, because once everyone tires of talking about Downing Street, the market’s collective gaze will once again shift east - and the picture won’t be any prettier than it was before.
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