US stocks fell slightly overnight, as weaker than expected consumer confidence and manufacturing data couldn’t push the S&P500 to record highs. Which is surprising, because the consistently weaker data of late has markets leaning toward the Federal Reserve ‘tapering the taper’ in its upcoming meetings, meaning more money to play with.
As US markets decide whether they’re going to keep going parabolic, or head south in a serious way, there’s something much more interesting going on. The performance of the Chinese yuan of late has gained plenty of attention. It’s interesting because this latest little experiment from the People’s Bank of China (PBoC) could have major ramifications.
The yuan is in the spotlight because it’s been falling against the US dollar for the past six days or so, reversing a long term trend of steady appreciation within a defined trading band. It’s rumoured that the PBoC is intervening to drive the yuan lower. As you probably know, the PBoC pegs the yuan to the US dollar, and only allows it to trade within a certain trading range. In other words, it’s not a freely floating currency like most others are.
As you can see from the charts below (courtesy of the Financial Review) there has been an abrupt change in the direction of the yuan recently. It’s widely rumoured the change is the direct result of PBoC intervention. The moves are not huge in terms of percentages, but they are still significant given the message the PBoC is trying to send.
Yuan – About Turn
Before we get to that message, a little background on the yuan. Like everything else in China, currency and capital flows are heavily regulated (except the air quality – apparently there are just some things the central planners cannot control).
There are two types of yuan. An ‘onshore’ yuan that trades inside China with the currency symbol CNY, and an ‘offshore’ yuan that trades in Hong Kong under the currency symbol CNH. China created the offshore yuan in 2010 as an important first step to ‘internationalise’ the currency. It did so by issuing bonds denominated in yuan (CNH) which foreigners were allowed to invest in.
This became known as the ‘Dim Sum’ bond market and was very popular with foreign investors. The main attraction was that the yuan was an undervalued currency and this gave investors an opportunity to bet on a rising yuan versus the US dollar.
And bet they did. In the year following the creation of the offshore yuan market the CNH became the world’s 17th most traded currency. Now, just over two years later, it is the 9th largest. According to the Wall Street Journal, trading in the yuan has exploded recently, tripling to US$120 billion a day from 2010 levels.
But it’s not just boring old bonds that the market is playing in. In what’s become emblematic of the central bank liquidity fuelled world of speculating trading, it’s the derivatives market where all the action is.
From the Wall Street Journal:
‘In the past year, trading in derivatives tied to the currency have soared as investors bet on a continued rise in the yuan. According to Deutsche Bank, approximately $250 billion worth of these derivative contracts were traded in 2013, the first year these products took off. Already in 2014, between $80 billion and $100 billion have been traded, the bank says.
‘Individual investors and small- and medium-size businesses were among the biggest buyers of options that would profit from appreciation in the yuan, currency analysts say. They bought structured investment products that magnified gains but could lead to big losses if the yuan fell below certain levels. The rising yuan coupled with higher interest rates inside China led even more investors to buy yuan, pushing the currency higher.‘
So, because EVERYONE knows that the yuan is an undervalued currency EVERYONE seems to have had a punt on its expected rise. Not just an ordinary, plain vanilla punt, but a leveraged bet using highly volatile derivatives.
But it’s not quite as simple as derivative punters taking a bath on a one-way bet gone wrong. There’s another twist to the story, which is why the PBoC is rumoured to have intervened heavily this week. The twist is the ‘US dollar carry trade’. This refers to the practice of many in China who borrow cheap US dollars in Hong Kong, then sell them for yuan and invest in high yielding ‘wealth management’ products.
The ‘carry’ (the difference between the low cost of borrowed funds and the high return offered by the wealth management products) is hugely profitable. And the fact that the yuan is undervalued and set to appreciate makes it an even better bet.
Tying all this together means that the authorities are having quite a tough time slowing down the runaway credit boom. They’ve tried to tighten liquidity inside the country, only to find that it’s still flowing in via Hong Kong. This flow of ‘hot money’ looks like the target of its latest policy moves.
But it should be careful what it wishes for. If it scares off the flow of capital coming in via Hong Kong, it could inadvertently pop the credit bubble. That’s because this money is sustaining the bubble right now.
If this happens, loss of confidence will see formerly abundant liquidity dry up and the PBoC will have to print its little heart out to stem the tide. This will further unwind the leveraged bets on yuan appreciation and cause general havoc in the market.
When everyone agrees on something, you can bet the market will do the opposite. Given the one-way bet on the yuan in recent years, maybe it’s time to think about the implications of a falling currency?
Speaking of falling, the iron ore price is at a seven month low. Tighter credit in China will slow property construction, an industry that consumes nearly 50% of China’s steel production. This doesn’t bode well for iron ore prices given the huge amount of new supply hitting the market in 2014.
Many provinces plan to reduce steel output given worsening air quality in some regions. There are thousands of steel mills in China, and many are old and heavy polluters. But they’re also heavy employers, so the logic of shutting them down to improve air quality is not always apparent. Widespread health hazard versus rising social unrest…generally the health hazard will win out every time.
Just chalk it up as another injustice brought about by easy money and heavy handed regulation. And the solution that these clowns come up with to clean up the mess they created? Do more…always with the need to do more…
We really are screwed…
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