I know it’s the 4th, which means we’re supposed to be talking only about America, but we need to talk about the other world power in what is increasingly becoming an international system characterized by bipolarity.
What country do I mean?
Let’s say, China.
It’s becoming painfully obvious that we’re about to see a repeat of the vicious yuan short squeeze that unfolded in late May/early June.
I talked quite a bit about this a couple of days ago in “Meanwhile, In China: ‘Relentless, All-Round’ FX Shenanigans.”
See, the PBoC has a problem on its hands. They effectively tried to frontrun the June Fed hike by rolling back the yuan liberalization push a couple of weeks ahead of the FOMC meeting.
At issue was the very real possibility that if the Fed didn’t get the messaging right and the hike was perceived as overly hawkish, rate differentials between the US and China would compress, exacerbating any latent capital outflow pressure.
Earlier this year, the PBoC combatted that by hiking OMO rates hours after the Fed hike. At that point, rate differentials were much tighter than they were heading to the June hike, which means there was no time to lose.
But since then, it’s become readily apparent that the shadow banking complex in China has absorbed all the tightening it can absorb in the short-term. Any more and you could see vicious unwinds in the trades financed via shadow channels or, more simply, you could see further mayhem in the metals and more anomalous action in the bond market (think curve inversion).
So with further OMO hikes not a viable (or at least “not a palatable”) option, the PBoC simply added what they euphemistically called a “counter-cyclical adjustment factor” to the yuan fix, a move which amounted to a rollback of the regime put in place in August 2015.
Around the same time they rolled out the new fixing mechanism (which is laughably opaque), the PBoC also engineered a funding crunch. The end result was a brutal short squeeze and, ultimately, an offshore yuan that suddenly traded notably stronger than its onshore counterpart which itself began to trade at a premium to the fix.
But as noted in the linked post above, that was short-lived. Soon enough, the offshore spot starting trading weak to where the onshore yuan was trading again and, perhaps more worrisome, the onshore spot started trading at a discount to the fix (again). In fact, that discount lasted for 17 straight sessions until, starting on June 20th and continuing into late last week, the PBoC started intervening in the spot market. That caused traders to rethink things and sure enough, the spot started closing at a premium to the fix again. Here’s the chart:
Well, guess what?
Either traders are going to try and test the PBoC or there’s pent-up outflow pressure, because the spot is trading at a discount to the fix again. The two red boxes in the chart below represent, in order, the short squeeze mentioned above, and the latest effort (the one that culminated in multiple rounds of spot market intervention last week) to push the yuan stronger:
Here’s SocGen’s Jason Daw:
Spot-fix gap keeps coming back
- No matter how hard the authorities try, it is proving difficult to eliminate the discount of the 430pm CNY closing price to the daily reference rate (i.e. fix).
- USD-CNY was trading lower (by an average of 224 pips) than the fixing level leading up to the suspected intervention in late May. In the five trading days before the suspected intervention on June 27 the average discount was 140pips.
- In both cases following intervention, the CNY traded stronger than the fix but only temporarily and quickly returned to a discount. The same is occurring in the past two days – the spot rate yesterday was trading 125 pips weaker than the fix.
- If the authorities view this as reflecting latent capital outflow pressure or speculative activity, intervention could become a more regular occurrence.
As a reminder, that is the kind of shit China does not need right now.
They’re already concerned that the effort to tighten the screws on shadow banking will end up choking off the economy. They will be in no mood to tolerate pressure on the currency. Which means you can expect them to crack down brutally on shorts if this keeps up.