FX Update: Unease in Chinese markets sees modest contagion

FX Trading focus: Unease in Chinese markets drives modest contagion

While we await a not-so-anticipated FOMC meeting (and the accompanying irony that the lack of anticipation means that it would take very little to surprise the market), the development most worth noting is the significant meltdown in Chinese equity markets as regulators there move against a variety of companies based on imperatives for the country’s leadership that are rather well described in a Bloomberg article. Hard to tell where this situation can take us, but a further stampede by foreign investors out of Chinese equities or second guessing of formerly passive allocations to the Chinese market could drive a widening contagion into regional FX to start, but even globally at the extreme. Within G10 FX, one obvious focus is on the JPY, which has backed up higher in rather modest fashion on the two-day blood-letting in Chinese equities, as the Japanese equity market bounce from recent lows has proved far more modest than elsewhere. In addition, the Aussie and kiwi are important to watch, with the latter likely far more vulnerable on a significant further spike in regional unease, given the huge shift higher in NZ short rates that could partially unwind, all while short AUD rates have remained pegged at low levels, unable to respond to the rise in rates elsewhere, as the RBA’s dovish guidance has weighed.  As well, we have seen a huge jump in copper prices which could revive interest in Aussie from the commodity resurgence angle.

US markets are in a world of their own recently, particularly the mega-caps, with the largest of these set to report today and in the days ahead. At the same time, yesterday saw US real yields marking their lowest level ever as a measure of the 10-year real rate dropped below -110 bps, suggesting that investors are struggling to find investments (besides incumbent mega-cap stocks) that will bring a positive real return as inflation is expected to persist. In fact, while nominal rates have traded sideways over the last few days, breakeven rates have surged, driving the deepening drop in real yields.

Chart: NZDUSD
NZD could be one of the more vulnerable currencies in G10 FX to any significant widening of regional contagion in Asia on the back of the turbulence in Chinese markets that may have global portfolio managers second guessing allocations as well as to the general growth outlook of the region. While NZD rates are so far unfazed, the “beta risk” is greater on a general change of mood on the global forward outlook than perhaps any other G10 currencies. Among regional comparisons, AUDNZD is also interesting to watch for the same reason as noted above. Technically, the downside risk was corralled after the pair broke lower, but with no follow through higher, so the next steps here are an open question. A failure through 0.6900 could set up a challenge toward the pivotal area near 0.6800 and even the 200-week moving average near 0.6760.