Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Drop everything else, it’s only about USDCNY 7.00
John J. Hardy
Chief Macro Strategist
Summary: FX Traders sole focus for the moment should be whether the renminbi stands or falls through its floor and USDCNY trades significantly above the 7.00 line in the sand. Already overnight, a very marginal new high in the rate above 6.95 saw widespread unease, but this is only a warm-up for the vicious volatility potential if China allows the CNY to float here.
FX market action remains rather muted relative to the tremors in the equity market of late, but that shouldn’t lead us to believe that conditions in the FX market will remain quiet if this storm continues. That’s particularly because the recent USD strength is pushing very hard on the USDCNY exchange rate and the CNY, or renminbi floor that has been established by China ahead of the 7.00 level is suppressing volatility in currencies as the world watches and waits whether the world’s most important exchange rate will remain contained.
The pressure on this level to give way is enormous as the Chinese currency remains overvalued on a real effective basis and as the country has moved to ease monetary policy to support its deleveraging efforts in recent months. This at a time when the Fed has continued to tighten policy via rate hikes and quantitative tightening (reducing its balance sheet), tightening USD liquidity the world over.
There have been similar if still different situations to the current one in the past: for example, the Swiss National Bank’s franc ceiling vs. the EUR that was abandoned in January of 2015 as the European Central Bank was set to launch its massive QE programme. An earlier example is Japan’s defense of the 115.00 area in USDJPY back in 2003. The franc situation was the worst one for market participants as the exchange rate was completely quiet and provided no inkling of what was about to unfold until an explosion of unprecedented force when the SNB stepped away from defending the franc ceiling. The 2003 JPY episode saw speculative attacks of hundreds of billions of dollars from market participants and nervous price action before Japan’s ministry of finance finally stepped away and allowed USDJPY to fall. Because the market had moved so aggressively and wanted to take profit, the price move after that episode was far smaller and slower.
Chart: USDCNH
The onshore USDCNY rate is the more important anchor here, but the USDCNH is the only way to trade the Chinese currency offshore, and drifts a bit from the USDCNY rate. Still, it is clear that the 7.00 level is the crucial one for whether we are set for a new wave of cross-market volatility if China “devalues” or even simply allows the renminbi to float and for the exchange rate to drift above this level on its own accord due to market pressures.
What happens if the renminbi devalues?
Part of the answer depends on how the price action develops. A chaotic, gap-like move of more than a couple of percent with a continued slide in the wake of the initial move would prove the most disruptive and would up-end risk appetite the world over, kicking weak asset markets when they are already down in what could be a worse version of the August 2015 renminbi devaluation announcement and the ensuing deflationary fears that washed over global markets – especially emerging markets – until early 2016 when the Fed raised the red flag on the USD strength and China stepped into staunch the CNY weakness. The idea is that a weak CNY is deflationary and turns the inflation risk narrative on its head. Global commodity prices would be hit hard as would risky asset prices in general.
What would do well? The general rule in events is that only the most liquid instruments do well – so the US dollar and US Treasuries would likely spike. The weakest currencies in this scenario would likely be the most China-linked exporters like Singapore (SGD), South Korea (KRW), Thailand (THB), Indonesia (IDR), Malaysia (MYR), etc. and even AUD and NZD. But in general, any smaller currency would likely perform poorly. Elsewhere, it is uncertainty whether the JPY would outperform even the USD – positioning would suggest that the JPY could be an even bigger mover than the USD to the upside as Japanese savings sloshing around the world look to deleverage and as the market is still rather short of JPY.
A less severe move in the CNY to the downside could still see a lower volatility version of the above.
Beware of the volatility acceleration
Just overnight we got a sense of how sensitive other markets are to a CNY move. The USDCNY rate was allowed to drift to new highs for the cycle and for the last decade, but still less than 0.18% above the previous day’s highs. This was enough to push AUDUSD almost a full percent lower to new lows for the cycle after the pair had traded in a narrow range in previous days.
This small example would likely be multiplied many times over on a real move in the CNY exchange rate of a mere full percentage point lower or more as the market won’t have a feel immediately for how the exchange rate might be allowed to go. The rising volatility in all asset classes triggers the classic deleveraging that sees correlations across markets rapidly heading to one, aggravating the search for safe havens.
Right now as of this writing, markets are trying to find a bit of comfort as the USDCNY rate drifts back below 6.94 after touching that ten-year high at 6.9682 overnight, but if the Chinese authorities want to send a stronger message that they don’t want to allow a CNY float to unfold, they will need to take the level much much lower (CNY stronger) – back to perhaps below 6.80 or lower. Stay tuned and understand that this exchange rate and China’s management of it over the next days will determine everything.
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