The Overnight Report: Currency Shock

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By Greg Peel

The Dow closed down 212 points or 1.2% while the S&P lost 1.0% to 2084 and the Nasdaq fell 1.3%.

China Cracks

What a difference a day makes. Yesterday global stock and commodity markets were all strong on the back of anticipation Beijing would shortly come in with hard hitting stimulus measures, given the weekend’s very weak Chinese trade and inflation data. But no one anticipated what came next.

Yesterday the PBoC devalued the renminbi by 1.9%. It is not the quantum that has spooked global markets – it has not been unusual for the euro, for example, to move by such an amount in a session in recent times – it is the implications that have frightened markets.

For years during the China boom of last decade, China’s trading partners cried foul over significant undervaluation of the renminbi, via the PBoC’s pegged currency policy, providing China with an artificial export advantage. In its attempts to reform its markets, thus to compete equally with Western open market economies, China has been revaluing that peg ever since, eventually wiping out what was once seen as 40% undervaluation.

But Chinese growth has now slowed. Beijing’s attempts to revive growth, through interest rate cuts, RRR cuts and various fiscal measures have, to date, failed. China’s export economy has suffered as all around its major trading partners have resorted to QE, which effectively promotes currency devaluation. China’s interest rates are not at zero but either way, China has no tradeable government bond. QE was never an option.

Instead, Beijing has simply devalued its currency. Given the government was intending to move the renminbi to full-float status as part of its ongoing reforms, such manipulation is a step backwards. But the PBoC pegs its currency every day, and has indicated it will now take direction from the CNY – the currency allowed to be traded outside China. Overnight the CNY has already anticipated another 2%-odd devaluation. The PBoC may well move again this morning. In a sense, China is trying to mimick some sort of “float”.

The ramifications, nevertheless, are worrisome. Firstly, commodity prices tanked overnight. They are US dollar-denominated and China has devalued the renminbi against the dollar, reducing the purchasing power of the renminbi to buy commodities in US dollar terms. The good news for the likes of Australia is that as a result, the Aussie dollar has also been sold down heavily, down 1.5% this morning to US$0.7303. The RMB-AUD effect is thus minimalized, with regard the trading price of iron ore, for example.

The Canadian dollar has seen the same sell-off for the same reason. From the outside looking in, less purchasing power in the renminbi leads to lower commodity demand from China. But from the inside looking out, if the export currency is also lower, equilibrium is maintained.

But the yen is another currency that was hit last night, and Japan is not an exporter of raw materials. It is an exporter of finished goods and thus a major competitor to China. The yen has been sold in anticipation the BoJ will now be forced to respond with more QE. Take it to the nth degree, and what markets really fear is an internecine escalation in the global currency war.

Result Concerns

On the local market yesterday, it was not a good one for earnings results. Cochlear ((COH)) disappointed and fell 7%. Domino’s Pizza ((DMP)) had a wild ride, plunging initially before recovering, while Transurban’s ((TCL)) result was not that well received either.

Yet we started to the upside, before swinging suddenly back to the downside. Leading that charge were the banks. After one day’s recovery from Monday’s big ANZ-inspired plunge, it seems the markets are not yet comfortable with bank valuations. Commonwealth Bank ((CBA)) reports today [and has done so, see below].

Then there’s the matter of the renminbi devaluation. It’s a bit difficult to know just what the impact will be on Australian exports – not only of commodities but also of tourism, education and so forth – given it depends on what the Aussie does. Indeed, the only two sectors to finish in the green yesterday were materials and energy, both up 1%, but possibly due to Monday night’s rally in commodity prices.

The situation was very different last night.

Commodities

Base metals rallied strongly on Monday night in expectation of Chinese stimulus, and collapsed last night when that stimulus turned out to be currency devaluation. Aluminium fell 1.5%, copper, lead and tin fell 2.5-3%, nickel fell over 4% and zinc fell almost 5%.

Iron ore returned to trading following the Singapore holiday, but only fell US40c to US$55.90/t.

Oil did not get off so lightly, with West Texas falling US$1.59 to US$43.21/bbl and Brent falling U82c to US$49.41/bbl.

Gold is not a commodity per se, and is up US$4.60 at US$1108.70/oz on a US dollar index which, on the balance of trading partner currency moves overnight, is flat at 97.17.

Wall Street

The US is the biggest loser. On the one-hand, weaker commodity prices on the back of reduced Chinese purchasing power impact on prices received domestically, given the US does not meaningfully export its commodities. But it does export manufactured goods and services to China, and here the reduced purchasing power effect is evident in the likes of Apple shares, which fell 5% overnight.

All up, the gains seen on Wall Street on Monday night were wiped out last night, when China did not do what anyone was expecting. But the other issue to consider is: what does this mean for Fed policy?

If China has now triggered another round of currency wars, it does not seem a good time for the Fed to be making its first rate hikes. US exporters are already crying foul over the strength of the US dollar. China’s move may well be the left-of-field event which prevents a first hike in September.

Which puts the Fed in a difficult position. Already it has been suggested that were China’s currency devaluation to continue, the US economy might head into recession. If the Fed has not raised rates by now, it has nothing to cut again to prevent such a result. That only leaves one policy alternative – a return to QE – and that’s really not what the Fed, or anybody else in the US markets – really wants.

The US ten-year yield closed down 10 basis points last night at 2.14%, having at one point seen 2.01%.

Today

The SPI Overnight closed down 28 points or 0.5%.

The world will hold its breath for another move from the PBoC.

Adding fuel to the fire will be today’s scheduled Chinese data dump of July industrial production, retail sales and fixed asset investment numbers.

In Australia, we’ll see the June quarter wage price index, which will be closely watched by the RBA, along with Westpac’s monthly consumer confidence survey.

It’s a big day on the earnings front. As we speak, CBA has gone into a voluntary trading halt. The bank has reported its FY15 profit and announced a greater than anticipated $5bn capital raising. The CBA board must be livid ANZ jumped the gun on them.

Today’s reporting highlights also include AGL Energy ((AGL)), Carsales.com ((CAR)), CSL ((CSL)), OZ Minerals ((OZL)), Primary Health Care ((PRY)) and REA Group ((REA)).

Rudi will appear on Sky Business' Market Moves, 5.30-6pm.
 

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