China’s Black Swan Yuan Fixes Are The Market’s New Plunge Protection

Things got off to a somewhat inauspicious start in the new week as the combination of a disappointing manufacturing PMI out of Beijing, the imposition of new tariffs and more violent protests in Hong Kong put the yuan on the back foot. (It recovered after the fix but we’ll see how things pan out.)

The Chinese currency is coming off its worst month on record, as ongoing trade frictions and unpredictable escalations stoked fears that the PBoC would countenance more depreciation in an effort to cushion the blow from the tariffs after letting the yuan fall through the psychologically important 7-handle.

Through it all, the PBoC set the fix stronger than expected day after day, with the implicit bias ratcheting higher towards the end of the month, an apparent effort to convey a preference for stability, as opposed to a desire to weaponize the bilateral rate. But the central bank’s aggressive use of the counter-cyclical factor to push back against depreciation pressure didn’t deter the market. Indeed, the yuan logged a 10-day losing streak (one day shy of a record) over the same period during which the fix was set much stronger than estimates for 8 consecutive days.

In short, you can thank the PBoC for helping to ensure things didn’t spin out of control in the days following Trump’s August 23 Twitter meltdown and subsequent decision to respond to China’s retaliatory measures with yet another escalation.

“Had it not been for the PBoC’s de facto intervention in curtailing [the] daily reference rate, CNY would have surpassed 7.30”, UBS wrote late last week, adding that Beijing was setting the fix stronger versus consensus estimates by an average of 195 pips. That, the bank marveled, “is a 6 standard deviation move”.

(UBS)

But, again, it hasn’t completely negated the market pressure. Not even close. Rather, all it’s done is guard against a steep depreciation.

“Despite authorities’ leaning against a sharp CNY weakness, they have not completely blocked market forces”, UBS wrote, in the same note. “Recent weakening pressure seems likely to be emanating from domestic investors’ hedging demand amidst a deteriorating growth outlook following a re-escalation of trade tensions”, the bank went on muse, adding that “the domestic bid for dollars (as measured through intraday onshore market changes) has been strong for the most of 2019, and has spiked of late”.

Have a look at a stylized breakdown of changes in the fix by three component parts:

(UBS)

Now that’s what you call an official bias to lean against market pressure.

Increased dollar demand could indicate that capital outflows are quietly picking up. Credit Suisse weighed in on this Friday in an expansive take. “We do see empirical evidence suggesting that capital outflow has increased, but in the near term we do not see capital flight similar in magnitude to that of 2016 in our baseline outlook, thanks to heightened capital controls and policies encouraging foreign investment”, the bank said.

Remember, net errors and omissions in the BoP data has increased materially of late. The NEO line item was -$88 billion for Q1 of this year.

For Credit Suisse, there’s some way to go before the risks would increase materially. “We see the new threshold point for the USDCNY exchange rate beyond which capital flight will become a greater concern at 7.4, but this level is not in our baseline outlook over the next 12 months”, the bank remarked, reassuringly.

Not everyone is convinced. Multiple desks have recently revised their USDCNY forecasts higher (i.e., yuan weaker).

“Chinese policymakers have been allowing the currency to depreciate to reflect numerous negative growth fundamentals, including the escalation of the trade war [and] this may continue to be the case going forward unless capital outflow pressure intensifies or speculative positioning becomes excessive”, SocGen said Friday, reiterating their take from earlier in the week. The bank revised their forecasts to show USD-CNY hitting 7.50 by 3Q20. “A move toward 8.0 is not inconceivable if the US raises tariffs to 30% on all Chinese imports”, they caution.

And yet, again on Monday, it looks as though the fix betrays an official bias for stability.

You can thank your lucky stars for that. If you learned anything from August 5 (and from August 2015, for that matter) it should be that as soon as the PBoC lets this thing go, risk assets of all stripes will almost invariably go with it.

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