We want to point readers to our previous article on the rout in various EM currencies, in which we opined that the dramatic weakening of the Japanese yen was likely an important trigger of these moves. We felt reminded of the Asian crisis in this context, which could ultimately be traced back to a succession of events, beginning with a massive unilateral yuan devaluation in 1994, which was soon followed by the yen weakening sharply from its 1995 blow-off top. The 'Asian Tigers' meanwhile had maintained currency pegs to the dollar, which led to large current account deficits and the build-up of credit and asset bubbles. Many companies in these countries borrowed in dollars, believing the pegs had removed currency risk. The outcome was not pretty.
In theory, there exists much greater flexibility nowadays - there are no longer any pegs, with the notable exception of the currency board arrangement of the Hong Kong Dollar, and many of the former crisis countries have used the time since the Asian crisis to build up large war chests in the form of sizable foreign exchange reserves. However, sudden capital outflows and sharply weakening exchange rates are still bound to have numerous knock-on effects.
Anyway, we were wondering for how much longer China would allow the yuan to appreciate in this environment and are therefore keeping a close eye on the currency. It may well be that the trend is about to change. In recent days, the yuan has weakened markedly, although the move is still small in a bigger picture context. Still, it is the biggest monthly downward correction in some time. If the yuan were to weaken further, we would have to conclude that China's leadership has decided that it is no longer advantageous to let the currency appreciate.
The yuan has been a one way street for so long now that we imagine all sorts of trading strategies have been implemented around this seeming one way bet. In other words, a significant weakening of the yuan may have numerous unexpected effects due to the interconnectedness of financial markets.
Below are a daily and a monthly chart of the yuan showing the recent moves. As can be seen, the daily values have been quite volatile for some time and the recent move has merely ended at the lower end of the trading range of the past two months. In terms of its extent, the move is therefore not overly noteworthy yet. It may still turn out to be just another blip. However, on the daily chart the recent move has acquired more of a 'trending character' than was exhibited by the short term volatility that preceded it:
The yuan, daily - after a great deal of volatility in January and February, a trend is seemingly crystallizing now
On the monthly chart, we can see that the recent correction is actually the biggest reversal in quite some time - the last time a similar move was seen on a monthly basis was in early 2012. Of course, that move turned out to be a mere pause - the yuan resumed its rally shortly thereafter. This time we have some doubts that the same thing will happen again. Political pressure on China with respect to the alleged undervaluation of the yuan has eased markedly, and in view of the much weaker Japanese yen and the rout in many EM currencies, there seems to be no good reason to let the appreciation of the yuan continue.
The yuan, monthly - the recent move is the biggest monthly correction since early 2012
Shanghai Stock Market - Bound to Make a Move Soon?
Meanwhile, China's stock market just doesn't seem able to get out of its rut… the larger downtrend remains intact so far, however, the decline has lost a lot of momentum over the past two years and the index has not made new lows since the spike down that occurred in the middle of last year. There may soon be an opportunity to play it for a trade, provided it continues to hold above last year's lows. A break of said lows would of course be bearish, but we currently don't expect that to happen. However, we think one should definitely wait and see if the lows will actually hold before making a commitment:
(click to enlarge)
The Shanghai stock market is still going nowhere. If it manages to maintain a sideways trend for much longer, then it may be time to think about playing it for a trade. Whenever a market becomes extremely dull, it is usually a good idea to watch it closely - just remember Japan's stock market in 2011-2012.
Conclusion:
One definitely should keep an eye on the yuan's trend. If the yuan actually begins to weaken more significantly, wider repercussions are likely to ensue. The downtrend in the yen seems to have added quite a bit of momentum to the weakening of exchange rates in many emerging markets, and it seems likely that a weaker yuan would add to the pressure.
China's stock market meanwhile has entered a phase of 'dullness' - at some point a playable rally will likely emerge out of the recent sideways movement. In the event that last year's lows are broken, another leg down in the bear market is going to be underway, which can of course not yet be ruled out in view of the larger trend. However, we think the probability that the market will eventually rally is somewhat higher (even a combination, i.e., first a sizable rally, then a move to new lows is of course possible). Usually markets that have been dull for quite some time soon cease to be dull.
Charts by: Investing.com, StockCharts
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