China And The ‘FX/Liquidity Contradiction’

While the world’s eyes are fixed squarely on U.S.-China trade tensions, traders are laser-focused on the asset that’s perhaps most exposed in the event the situation deteriorates further: the Chinese yuan.

After snapping a 11-day losing streak on Friday, the offshore yuan resumed declines on Monday alongside Chinese equities, which fell a disconcerting 2.5% as index heavyweights suggested capitulation.

As this continues to play out, the 2015 analog is becoming increasingly hard to ignore.

“As the dispersion of global growth momentum widens, fears are rising of contagion across asset markets and a disruptive doom loop in emerging markets,” SocGen wrote, in a note dated Monday, adding that “the parallels with three years ago are striking as the bear market in China’s equity market deepens and the pace of yuan depreciation accelerates, reviving memories of July and August 2015.”

One interesting thing about the setup this week is that assuming the Fed minutes don’t tip extreme consternation about the trade spat and assuming the June payrolls report continues to paint an upbeat picture of the U.S. economy, the policy divergence theme that’s serving to perpetuate the yuan slide could become more entrenched by the weekend, especially if the July 6 deadline on tariffs comes and goes with no resolution, which is a foregone conclusion at this point.

The policy divergence aspect of this story is important. When the PBoC decided not to follow the Fed (i.e., not to hike OMO rates after the June Fed meeting) it pretty much guaranteed that another RRR cut was in the cards. Of course you needn’t have read any tea leaves to know the RRR cut was coming – it was telegraphed explicitly by Chinese authorities and it underscored the notion that the Chinese economy is decelerating and that Beijing thinks a trade war might add to the pressure.

But loosening policy (and implicitly signaling an effort to de-emphasize the deleveraging push out of concerns for expediency in light of the increasingly fraught geopolitical backdrop) means the disparity between the Fed and the PBoC will grow. That undermines the yuan further and opens the door to capital flight.

Deutsche Bank’s Alan Ruskin calls this conundrum “China’s FX/liquidity contradiction”. Here’s an excerpt from a note out on Monday:

The extent of liquidity may well reflect tension between the official desire to achieve the trifecta of: i) supporting risky assets, ii) easing liquidity tensions, and, iii) supporting the currency. So far the currency is the obvious loser, and the market will take a view that as long as money market conditions don’t tighten, the currency will remain under pressure.

Of course all of that isn’t entirely consistent, especially to the extent the currency weakness is rattling the equity market. Ruskin goes on to suggest that SHCOMP 2638 (the 2016 low) would be a natural place for the vaunted “national team” to step in. That’s another 5% from Monday’s close:

As for the yuan, Ruskin thinks the pace of the depreciation is more important than any “level” (a reference to chatter about 6.70 being “critical”. He also cautions that the PBoC could do an about-face at any given time:

The money market, where the recent RRR cut and efforts to ease liquidity contradict any attempt to slow CNY weakness. The onshore and offshore forward points show extraordinary liquidity for this point of currency tension, and have yet to speak to any PBOC desire to defend the currency. The T/N carry favors long USD/CNH. Easy money market conditions could change quickly.

Take all of that for what it’s worth, but the overarching point is that all of the above speaks to a precarious situation for emerging markets. As Ruskin notes, EM sentiment in general is highly tethered to what’s going on in China.

Oh, and he also echoes the sentiments of BofAML’s David Woo who, in a note out Monday, said this:

If Washington cannot close a relatively easy deal like NAFTA, it is probably safe to assume that it is far from closing a deal with China.

Here’s Ruskin saying pretty much the same thing:

One sign that things could get worse before they get better is the view that of the various US trade tensions between Canada, Mexico, China, and the EU, surely Canada (even allowing for desired mid-term support from the ‘rust belt’) is the easiest to fix, while China is the toughest. It would seem unlikely that the US can fix the trade tensions with China before those with Canada, and the logical sequencing of deals by country suggest things could get worse with China before they get better.

Nothing further.