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We liked the yuan before China was cool, as the country song goes. When the yuan traded at 7.2 to the dollar last June, the brokerage-house consensus held that it would depreciate to around 8.0 to the dollar. With the yuan trading around 6.75 in the offshore market, most financial commentators see nothing but upside.
So do we, with a short-term caveat, namely the one we highlighted in last week’s Global Value Strategist: Rising US real interest rates create headwinds for risk assets around the world, including China’s currency.
Real rates are rising in the US because the Federal Reserve has nailed the overnight rate to the zero line, which means that falling inflation expectations translate into higher real rates. Perversely, that increases the real cost of money when the economy weakens.
In fact, the weakening US economy and continued strength in China’s economy portend a rising yuan. But the monetary anomaly created by Fed policy sometimes pushes against this trend.
All the fundamentals point to a stronger yuan:
- The interest-rate differential between Chinese and US five-year government bonds stands around 2.8%. The last time it was this wide the Chinese currency traded at about 6 to the dollar.
- Capital flows into China are accelerating, with foreigners’ fixed-income outlays running at a US$240 billion annual rate in July. After the inclusion of Chinese sovereign debt in the FTSE-Russell bond indices, this should continue. Bond market reforms will make it easier for foreigners to invest in Chinese fixed income, as William Pesek wrote on October 2.
- Surging Chinese exports lifted its current account balance to an annual rate of more than $600 billion during the second quarter. Total Chinese exports in US dollars rose 9.5% year-on-year as of August.
With 40,000 new cases of Covid-19 daily, the US is struggling to regain the economic ground it lost during the second quarter. Nonfarm payrolls for September printed at an anemic 661,000, below expectations, and the US Labor Department’s household survey shows an employment gain of just 295,000.
The household data is less precise, but it captures the devastation of small businesses who may not register on the survey of establishments. With employment gains slowing and emergency income subsidies expired, personal income dropped by 2.7% in August, the largest decline in seven years.
The orders component of the National Association of Purchasing Managers’ diffusion index fell in September, a poor augury for manufacturing.
China’s economy grew by 3.2% between the second quarter of 2019 and the second quarter of 2020, while the US economy shrank.
So why isn’t CNY already trading closer to 6 to the US dollar than 7 to the dollar? We think it will get there, but CNY will continue to hit some speed bumps on the way.
During most of the past two months, the yuan has traded like a risk asset, moving in tandem with other risk assets, for example the S&P 500.
Note that CNH’s upward trend continued despite the fall in the S&P. But short-term movements of CNH and the S&P are highly correlated. The chart below shows daily changes in the S&P versus daily changes in CNH. The inverse relationship is clear: Despite the rising trend of the level of CNH against the dollar, short-term declines in the S&P put pressure on CNH.
As we observed on September 27 (“US Fed needs to accept necessity of negative rates”), a weakening economy leads to lower inflation expectations. These are reflected in the yields of US Treasury securities. When economic expectations worsen and commodity prices fall, the real yield of US Treasuries (the yield minus expected inflation) usually falls to, because the market expects the Federal Reserve to adjust rates downward.
The trouble is that the nominal short-term rate set by the Fed is fixed at zero, and the expected short-term rate going out years (as reflected in the interest-rate futures markets) also is fixed at zero. When inflation expectations fall, the real component of interest rates is forced to rise.
Europe and Japan have used negative short-term interest rates as a response to weak economic conditions for years. It hasn’t been done in the US and the Fed appears to think that there is some magic barrier at the zero mark. But by pegging the real rate at zero, the Fed has inadvertently forced real rates up in tandem with falling expectations of economic growth.
That’s what economists call “procyclical,” a fancy word for a vicious circle. Real rates have risen while the US stock market fell, and econometric analysis suggests that rising real rates have led the stock market down.
Whenever a central bank nails a key rate to the wall, something crashes against it. Hong Kong’s interest market is a case in point. The Hong Kong dollar trades in a narrow band set by the Hong Kong Monetary Authority.
Hong Kong’s IPO wave creates buoyant demand for Hong Kong dollars, pushing HKD up against its upper limit to the dollar. That requires the HKMA to intervene, that is, to take HKD out of the money market and sell them against US dollars. This action has the effect of draining liquidity from the Hong Kong market, pushing up local Hong Kong dollar interest rates.
This de facto tightening of monetary policy creates speed bumps for the yuan’s upward trend. In the very short-term, the yuan looks like a risk-on trade. In reality, it’s a trade on fundamentals, namely China’s stronger economy, robust capital inflows, current account surplus and high real interest rates.
All of these push capital flows in the yuan’s direction, but short-term trading in risk assets can overwhelm the trend in the very short-term.
A lot of money is waiting on the sidelines, looking for the right entry point into long CNH trades. During a 24-hour period, September 29 to October 1, CNY jumped from 6.82 to the dollar to 6.73, one of the biggest one-day moves in history.
The jump occurred in the illiquid offshore market after China shut down for the Autumn Festival holiday. It apparently followed better-than-reported Chinese PMI data, which affirmed that China’s V-shaped recovery is continuing.
We expect more data surprises to the upside, especially in retail sales, a critical variable given Beijing’s emphasis on consumption-led growth under the “dual circulation” policy. Rising consumer confidence augurs well for retail sales during the coming three months.
Econometric analysis shows that changes in China’s Consumer Confidence Index (prepared by China’s National Bureau of Statistics) predict changes in retail sales with lags of one to three months.
I have incorporated these leads and lags into a forecasting model for retail sales, which indicates that the changes in consumer confidence during the past three months should be followed by a significant rise in September retail sales.
China’s manufacturing sector, which showed 5.6% growth year-on-year as of August 2020, leading China’s overall GDP growth, should remain a source of strength. Profits of China’s industrial enterprises meanwhile rose 19.1% year-on-year as of August.
Housing sales remain robust and housing prices are rising at low-single-digit rates, which is precisely what the government wants.
China’s recovery remains robust and positive surprises are in the data pipeline, and the yuan’s trend points upwards. The US Fed’s policy predicament likely will occasion temporary reverses but these will provide patient investors with cheaper entry points into long yuan trades.