Market Takes Yuan Drop In Stride, Majors Continue To Consolidate

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 |  Includes: FXA, FXB, FXC, FXI, FXY, UDN, UUP
by: Marc Chandler

The Chinese yuan extended its sharp drop for the sixth consecutive session. Today's 0.4% drop is the largest is the largest in almost two years and accounts for nearly half of the six-day decline. The fact that the spot rate ended weaker than the central bank's reference rate for the first time since September 2012 has raised eyebrows, but the international capital markets seem largely unperturbed.

There are several hypotheses about what is happening, but it is generally agreed that Chinese officials are behind the depreciation. Some suggest it is choosing now to alter perceptions of that the yuan only move in one direction. This could as a prelude to widen the band. Others suggest that it is designed to reduce carry-trade demand.

The PBOC confirmed last week that it would expanded the yuan's trading band in an "orderly" fashion this year. The yuan is allowed to trade in a 1% bands around the PBOC reference rate. It was last widened in April 2012 from 0.5%, which was an increase from the 0.3% in May 2007.

At the same time, the PBOC drained CNY100 bln from the banking system, but with little avail as the 7-day repo rate continued to fall. At 2.72% it has largely remained below the previous 4.0% floor over the course of the yuan's six-day fall. The Shanghai Composite dropped 2% on top on Monday's 1.8% decline. Over the past four sessions, it has slid 5%. The real estate sector is being particularly hard hit amid concerns of softening prices and tightening credit. A sub-index of real estate companies fell to its lowest level in nearly 8 months. Some see the weakening yuan as a symptom of a poorer economic outlook. In turn, the yuan weighs on earnings expectations.

The Australian dollar, often sensitive to Chinese developments, is consolidating yesterday's recovery, when it posted an outside up session (trading on both sides of last Friday's range and finished above the pre-weekend high) and closed at its best level since February 11. After resurfacing above $0.9000 yesterday, it has remained above there through the Asian session and the European morning.

Like the Aussie, most of the other major currencies remain within the ranges seen yesterday. Sterling is an exception. Recall that after falling through last week's lows (reaching ~$1.6585), sterling rebounded smartly to finish the North American session near $1.6655. It pushed briefly through $1.6700, ostensibly helped London morning fix buying some linked to Vodafone-Verizon. Strong mortgage approvals, the highest since September 2007 may have also provided some incentive.

The BOE's McCafferty warned that sterling's appreciation may impact MPC decisions, and that further sterling strength would be worrisome, though the current rate is not a major problem for exporters. On rates, McCafferty noted that expectations for Q2 2015 hike are "not unreasonable" and chance of an earlier or later hike are well balanced. The market demurs. The short-sterling futures curve clear implies asymmetrical risk of an earlier move.

In any event, McCafferty is not the only official talking about exchange rates. France's Montebourg continues to press his line that euro strength is unwarranted and should be resisted. He argues that the ECB is not respecting its inflation target.

Yet, the lesson from Japan's Abenomics is that a weakening currency does not necessarily boost exports very much. Nor is a weaker currency the key to arresting deflationary forces. Earlier today, Japan reported Corporate Service Price Index. It eased 0.6%, the first decline in five months. The year-over-year rate fell to 0.8% from a revised 1.1% in December, which was initially reported at 1.3%. There is some concern that Abenomics has reached the point of diminishing returns. The economy has begun under-performing. Consumer confidence has stalled and there is a decline in the sentiment among economic watchers. And the retail sales tax increase is around the corner (April 1).

The main focus in Europe is on Italy; both economics and politics. On the economic front, December retail sales were dismal. The 0.3% decline compares with expectations for a flat report. On a year-over-year basis, the 2.6% plunge follows a 0.2% increase in November. On the political front, Prime Minister Renzi faces a confidence vote in the Chamber of Deputies. Note while he won the vote in the Senate as widely expected, it was not a very inspiring outcome. His 169-139 victory compares with Letta's 233-59.

The North American session features US house prices, consumer confidence and the Richmond Fed manufacturing index. None typically are market movers. There is no Canadian data of note, but the Toronto Stock Exchange has advanced in 13 of the past 14 sessions, having posted a small loss before the weekend. The raw material sector has gained 18% this year. As a rough and ready proxy, we note that the CRB index has risen almost 12% off the January 9 lows. However, it gapped higher yesterday and although the gap was not completely closed, the CRB did settle on its lows yesterday, warning of the risk a pullback today.

The dollar tested CAD1.1055 yesterday and today after spiking to CAD1.12 before the weekend in response to poor retail sales data. The Bank of Canada meets on March 5 and is expected to retain a dovish stance, but not change interest rates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.