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Yuan Downside Breakout Is On And What It Means (Spoiler Alert: Nothing Good)

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Submitted by Eric Bush via Gavekal Capital blog,

 

The onshore yuan exchange rate (CNY) against the USD has eclipsed 6.74 today while offshore exchange rate (CNH) was pushing 6.75 as the week drew to a close. Current levels are at 6-year lows against the dollar and it will be interesting to see what happens as we approach 6.80-6.85 as this was the line in the sand for about two years from 2008 to 2010. All in all, however, it seems that the continuation of the devaluation that we have been waiting for is officially back on. So assuming that many of the strong relationships that have been in place the last several years hold, what should investors be mindful of?

 

Starting off with commodities, copper could be ready to take another leg lower and take out 2016 lows. Also, the current price of oil looks high.

 

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Even in a ZIRP world that feels awash with liquidity, a weaker yuan could negatively affect liquidity on the margin. China’s forex reserves are already $800 billion below 2014 highs. This declining trend looks set to continue. Additionally, liquidity in the US banking system will probably continue to be drained as non borrowed reserves decline.

 

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US economic prospects aren’t very bright with a China in currency devaluation mode. The non-oil trade deficit will probably continue to widen while overall corporate profits decline. Non-oil import prices will most likely continue to depress any sign of inflation which keep pressure on nominal GDP growth and non-residential fixed investment. Additionally, this could all depress breakeven inflation expectations as well.

 

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We would also expect to see fed funds futures creep higher (i.e. lower chance the Fed raises rates) especially in 2017. 2017 fed fund futures have already increase by 7 bps over the past week. We could also see a rally in long bond prices and higher USD 3-month LIBOR rates (which will make hedging costs for foreign buyers of treasuries more expensive).

 

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