Indifference to the yuan’s slide says much about the state of the markets
Its August 2015 devaluation feels like a distant memory
As recently as the spring of last year, a nearly 2 per cent decline in China’s currency in the space of a week would have sent global markets into a tailspin.
Fast forward 18 months, and the muted response on the part of international investors to last week’s 1.9 per cent decline in the yuan versus the dollar – the sharpest weekly drop since the surprise devaluation of China’s currency on August 11, 2015 which triggered a dramatic deterioration in sentiment – is one of the clearest signs of the persistent bullishness in markets in the face of mounting financial and geo-political risks.
While the onshore yuan hit a 21-month high against the greenback as recently as September 8, partly due to this year’s plunge in the dollar, the recent decision by China’s central bank to scrap two trading curbs designed to deter speculation against the currency reveal the extent to which sentiment towards China itself has improved and the degree to which global financial conditions have eased, in part because of the steep decline in the dollar.
In the same week in which the yuan suffered its sharpest fall in more than two years, the Shanghai Composite, China’s main equity gauge, barely budged, having risen 9 per cent since the end of May (in stark contrast to its 24 per cent decline in the six weeks following the August 2015 devaluation). Meanwhile the benchmark S&P 500 index gained a further 0.7 per cent, pushing it to a fresh all-time high.
Beijing’s success in stemming capital outflows and stabilising the yuan – China’s capital flow even turned positive in the first half of this year while the yuan is still up more than 4 per cent versus the dollar since the start of this year – has been helped by a confluence of favourable external factors that have pushed the dollar index (a measure of the greenback’s performance against a basket of other currencies) down nearly 10 per cent to its lowest level since April 2016.
These factors include investors’ perception that the Federal Reserve is unlikely to be able to raise interest rates much further because of subdued inflation, a pickup in global growth (especially in Europe), solid corporate earnings and the unwinding of the so-called “Trump trade” as the scandal-plagued US president struggles to advance his economic agenda.
Investors in developing economies, who in the six months following the August 2015 devaluation dramatically reduced their holdings of emerging market bonds and equities, have been the most bullish in recent months. In the three weeks since the yuan fell 2.6 per cent versus the dollar, inflows into emerging market bond and equity funds have risen by a further US$8.7 billion, according to JPMorgan.
Other investors keen on riskier assets have also brushed off the yuan’s recent decline. Inflows into US high-yield, or “junk”, bonds increased to nearly US$1.4 billion last week, a 10-week high, according to EPFR Global, a data provider. Meanwhile spreads, or the risk premium, on some US junk bonds have fallen to their lowest levels on record.
Make no mistake, if there was ever a time for China’s central bank to encourage greater volatility in the yuan, it is now.
Yet the external factors that have contributed to the improvement in sentiment towards China are showing signs of becoming less supportive.
Since September 7, the yield on benchmark 10-year US Treasury bonds has shot up 30 basis points to 2.33 per cent, its highest level since mid-July, while the dollar index has risen nearly 1.9 per cent, handing the greenback its first monthly gain since February.
The sudden, albeit modest, tightening in financial conditions stems from two potentially game-changing developments: a more hawkish-than-expected Fed that is pushing ahead with the withdrawal of stimulus despite its own concerns about low inflation and the Trump administration’s proposals, unveiled last Wednesday, for aggressive tax reform.
If the Trump trade makes a comeback – and the jury is still out as to whether it will – emerging market assets, particularly currencies, will come under renewed strain.
Inflows into emerging market equity funds fell 40 per cent last week as investors in speculative Exchange Traded Funds (ETFs) reduced their exposure.
Still, a sharp and sustained rally in the dollar is unlikely given heightened political risk in Washington and, more importantly, growing convergence in global monetary policies, with the European Central Bank preparing to scale back its programme of quantitative easing.
There is no sign, moreover, that investors are losing their appetite for higher-yielding assets, particularly given the large stock of negative-yielding government debt in Europe and Japan.
For markets, the August 2015 devaluation of the yuan feels like a distant memory.
Nicholas Spiro is a partner at Lauressa Advisory