This week investors will no doubt be focused on the events in Ukraine, the ECB meeting, and Friday's employment report, but there is a far more important development that could shape market prices for years to come. The single most important variable in global trade and cross-border capital flows over the past decade has been the relationship between the US dollar and the Chinese renminbi, a.k.a the yuan (CNY). Over the past couple of weeks this relationship has undergone some intense countertrend weakening that may portend a paradigm shift.
When China entered the WTO in September 2001, the CNY was pegged to 8.27 against the dollar, China owned $70 billion in US Treasuries, and oil traded $20/barrel. Today, with oil at $100, the CNY is 25% stronger and China has accumulated over $1.2 trillion in Treasuries. The currency peg has governed global trade, capital flows, and market pricing ever since, and if there is a change in this valuation, it is going to matter.
In 2005 the credit-induced US consumption bubble was full-blown, producing a $200 billion current account deficit at over 5% of GDP. The consumption bubble was subsidized by the artificially weak CNY peg, but that same year, China moved to a managed float; this allowed it to strengthen. Not coincidentally, a few months later the current account deficit peaked at $230 billion at 5.9% of GDP.
Between 2005 and 2008 the CNY strengthened by 17% and the US current account deficit started to narrow. Since the re-pricing of the CNY helped reverse the current account deficit, it could also be considered the catalyst for a reversal in the consumption bubble, which ultimately led to a collapse in the credit bubble and the 2008 financial crisis.
US Current Account Deficit
Since the financial crisis, the US current account deficit has continued to narrow, but the Fed's QE program has replaced these exported dollars. On February 3 in With Fed Taper, Rebalancing of Global Trade Set to Begin
, I described how QE has become the de facto US current account deficit that was the engine for global trade:
While the initial market reaction was the re-pricing of positions, the current market reaction is more about a re-pricing of economics. [F]irst it was a US consumption bubble that exported the dollars that fed global trade, then QE stepped in to provide liquidity -- in effect, subsidizing US consumption. The 2008 financial crisis was as much about a rebalancing of the US consumption-led current account imbalance. While the US consumer has adjusted by reducing consumption, QE prevented prices from adjusting. Now, with the Fed pulling liquidity that manufactured demand, foreign currencies must fall to a level that equals real US demand.
CNY Vs. JPY
CNH Vs. 12-Month Non-Deliverable Forward
Because the CNY is pegged within a trading band, there are proxies for participants to gauge market flows and discounts. There is the 12-month non-deliverable forward CNY that can be seen as a proxy for the market's discount for future trading band bias. Because capital flows in China are limited, the Hong Kong "offshore"-based CNH is more freely traded and can be seen as a measure of capital flows into and out of China. Under this current account deficit/QE dollar-exporting regime, the weakening USDJPY could also be seen as a proxy for the USDCNY.
During this weak dollar cycle the CNY 12-month forward value consistently priced in a stronger CNY spot, but when the Fed pulled QE2 in June 2011, there was a noticeable reversal in CNY proxies. The USDJPY bottomed, the CNH fell 3%, and the CNY forward crossed CNY spot, discounting future yuan weakness. The CNH quickly rebounded to get in line with spot CNY which continued to strengthen. However months later, in 2012, with the onset of Abenomics in Japan, the USDJPY would explode higher and the CNY forward would maintain its weak bias.
In the spring of 2013, when the Fed first floated the tapering idea, currency markets immediately began to re-price this removal of liquidity. The dollar rallied against the yen, and many emerging market currencies but the yuan continued to strengthen. When the Fed announced tapering QE at the December 18, 2013 FOMC meeting, both the CNY and CNH were at respective highs against the US dollar, however, as the Fed has reduced stimulus, there has been a sequence of events that could be indicative of a change in trend.
CNH Vs. FX Reserves
In 2011, when the Fed stopped QE2 and the CNH dropped, there was a corresponding drawdown in FX reserves held in custody at the Fed. When the Fed announced that it would taper QE on December 18, 2013, FX reserves again began to decline. Now, a few weeks later, we are similarly starting to see weakness in CNH, only this time, unlike in 2011, the CNY is weakening in concert. This is a significant difference.
CNH Vs. CNY
The following is from Alex Frangos of the Wall Street Journal
The yuan took its biggest dive against the dollar Friday since it depegged in 2005, down at one point nearly 1%, a massive move for a currency that on average fluctuated up or down around 0.06% a day the past two years. What began as a concerted effort by the central bank to guide the currency lower is now being reinforced by market participants, who play in the tight pricing corridor in which Beijing allows the currency to be traded onshore.
More worryingly for some investors are the risks built up in the freely traded offshore yuan in Hong Kong. Analysts at Morgan Stanley and Deutsche Bank have identified roughly $350 billion worth of structured investment products that could produce losses should the yuan continue to plunge. Several have identified a level of 6.20 yuan per dollar as a trigger point for contracts to accelerate losses. The yuan fell as low as 6.18 on Friday.
As the Wall Street Journal
article suggests, there is a perception that the CNY weakening has been orchestrated by the People's Bank of China (PBOC) to curtail hot-money speculative flows. With weakness ignited in the freely traded CNH, it suggests either there is unwinding of leveraged CNY positions, possibly due to QE tapering forcing short dollar carry trades to cover, or money is fleeing CNY assets in anticipation of a weaker CNY because of PBOC easing (or both). The PBOC understands QE dollar subsidy is going away and perhaps it knows that it must weaken the CNY to protect its export-based economy. The excuse may be to curtail speculation, but the real reason may be to ease policy.
If the PBOC needs to weaken the CNY to sterilize the impact of the reduced dollar supply, it could have major implications for global market prices. It's not clear what level of CNY would balance the Fed's removal of stimulus, nor is it clear that the markets will take this adjustment lightly. The measured pace of Fed tapering is no doubt an attempt to calibrate market discounts of liquidity. However, if the market gets unruly and leveraged positions come under pressure, there could be an increase in volatility, which would increase risk premiums.
The most common excuse for the weakening US economic data of late has been the wintery weather that consumed much of the country over the past couple of months. However, over the same time, we are witnessing potential paradigm shifts in historic economic and market regimes. The US current account deficit is narrowing, the Fed is reducing an unprecedented amount of stimulus, FX reserves are being sold to combat capital flight, and the value of the US-China currency relationship is reversing a decade-long trend. To say these events aren't responsible for changes in economic activity would be naive.
Since the Fed started tapering, there has been an insatiable demand for bond duration and the curve trades with a flattening disinflationary bias. Some might argue that bond yields are responding to a weather-related economic deceleration. But if stocks don't care about weather, why should we expect bonds to care? I think there is more to the story. Is it a paradigm shift? I don't know, but central banks are moving, money is moving, and prices are moving in that direction.