Currency market flashes an amber warning

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Emerging market currencies are flashing amber and a red light looms with a likely test of a key level in China’s renminbi not seen since 2008. Currencies are the tip of the spear for big shifts across financial markets. A test, let alone a break of the Rmb7 per dollar level, will reverberate broadly, as shown by Friday’s weakness across EMs that buffeted European and US equity markets. The resilience of equities for much of this month and other risk assets faces a major challenge should the lights change to a code red. 

A week of sharper rhetoric and actions between the US and China leaves the offshore renminbi trading at Rmb6.94. This represent the weakest level for the renminbi since November when markets were last anxious about a test of Rmb7, a line in the sand that held last year and also back in late 2016. More broadly, EM currencies have endured their worst week since the Turkish lira slumped last summer.

As the chart of the onshore and offshore levels of the renminbi show, the direction of travel looks tough to halt. 

Clearly the big story is how much renminbi weakness is tolerated by Beijing. Many think it will break Rmb7 and to some extent a weaker currency helps to act as a shock absorber. (Just look at how a weaker pound in the wake of the Brexit referendum helped the UK economy handle that blow.) Escalating trade tension only compounds Beijing’s challenge of rebalancing a slowing and highly indebted economy. 

Driving the price action is the hardening of battle lines between Washington and Beijing. The targeting of China’s technology sector by the Trump administration this week has prompted China’s Xinhua news agency to say that until the US makes concessions it would be “meaningless” to continue talks.

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George Saravelos at Deutsche Bank says stand by for a break of Rmb7 per dollar:

“With the trade war likely to be protracted, finding ways of keeping domestic growth supported should be a priority for policymakers. This is likely to require looser monetary policy, which could come at the cost of a weaker currency. Authorities should be more willing to bear that cost this time.”

Allowing a sustained slide in the renminbi has the potential to spur a wave of risk aversion that can easily fan the flames of a bigger blaze. And perhaps the big risk is that a weaker renminbi may well prompt higher tariffs from the US in response. 

Deutsche highlight that US tariffs will set the tone for where the renminbi trades and they estimate:

“The latest increase in tariffs to 25% on $200bn of goods is consistent with USD/CNY close to 7.10. If Trump proceeds with tariffs on $300bn, even at an initial 10% rate, this could take USD/CNY to 7.40.”

A weaker renminbi in the currency world entails a firmer yen, with blowback for Japan’s economy and share market, alongside weaker commodity currencies such as the Australian dollar. The Singapore dollar has just suffered its worst week since October, while the New Taiwan dollar has notched its biggest one-week declines since that time. It’s hardly surprising that EM bond funds recorded their largest outflows since June 2018 in the week to May 15, according to Barclays. 

Callum Thomas of Topdown Charts notes the “bottom line” from Rmb7 breaking:

“Puts a number of other markets at risk, with Asian FX, EMFX, and EM equities at the epicentre.”

The case for Beijing stemming a sharply weakening renminbi is that the last thing the government needs is another bout of capital flight and broader market turmoil. Also a sustained drop in the renminbi would hurt China’s efforts in opening up its markets to the rest of the world as more foreign investment funds are buying mainland shares and bonds, a trend gaining momentum from index groups increasing their China weightings.

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A pivotal week in currencies and markets appears on the cards with plenty of action looming from whether a major level in the renminbi holds or folds.

Brad Bechtel at Jefferies highlights the importance of the number 7:

“Not sure China has the appetite or desire to let the currency go nearly that much but once the noise around a break of 7.0000 is done and the dust settles, we could see a further move to 7.2000 pretty easily. Unless the trade issue is resolved and tariffs removed of course.”

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Reader feedback 

A couple of readers responded to this week’s note penned on the German 10-year Bund yield dropping below Japan’s benchmark, in my view an unsettling development to put it mildly. With the German Bund yield on Friday pushing beyond minus 0.10 per cent, this represents another amber alert for investors. 

One reader highlights how I mentioned the word “stimulus” four times in the note and came to this conclusion: 

“The world has thus come out of (has it?) of an unprecedented monetary stimulus kept in place for nearly a decade — unprecedented in scope, magnitude and duration. Yet, barely a year later, if almost all parts of the world require further stimulus, what does it say of its effectiveness or, more importantly, desirability, considering all the unpleasant consequences it has engendered, in its wake?”

Another reader perusing the chart of German yields below those of Japan in the same note made a contrasting point:

“What I saw when I looked at your chart was a great buy signal for stocks. At least it was the last time the Bund dropped below Japanese yields in late-2106. Yes, it signals deflation concerns but it may be precisely those concerns which bring excessive policy help combined with much lower yields which lead to sparking the stock market. Could this happen again today?”

Here’s the Bund/JGB chart from that note. Have a good weekend.

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Quick Hits — What’s on the markets radar

Red flags in real estate — Stimulus via low long-term interest rates has certainly been a boon for real estate. UBS has taken a look at global markets and created a table that shows the red flags for the likes of Canada, Japan, China, Australia and Hong Kong. However, “balanced risks and returns” are seen in the US, the UK, Europe, Germany, Switzerland, Singapore and Brazil. 

UBS highlight that a search for quality assets among investors “has triggered a convergence of prime initial yields across countries and sectors”. 

Thanks to low interest rates, the bank believes:

“In comparison to previous cycles, investors should still be able to manage balancing risks and returns to favor real estate investment over other investment opportunities.”

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Your feedback

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