How To Navigate These Dangerous Markets

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Includes: CNY, DIA, OIL, QQQ, SPY, USO, VXX
by: Shareholders Unite

Summary

The markets are extremely dangerous territory right now.

It is all about China: The risks of a substantial yuan devaluation are considerable, but not necessarily imminent.

This means that the risks are large, but medium-term. We provide some pointers regarding what to look out for as you navigate the markets.

We have a bit of a bounce in the market at the time of writing (pre-open on Wednesday, January 13), but for how long— and, more importantly, what should we look out for? Here are a few indications of further trouble:

  • Soft data out of China
  • Declining onshore yuan fix
  • Increasing spread between onshore and offshore (Hong Kong) yuan
  • Spikes in the Hong Kong interbank offered rate (HIBOR)
  • Further oil price decline

The China crisis is serious, but not necessarily imminent. The PBoC still has plenty of reserves to hold the line, for now. But it is getting tighter, says The Telegraph:

China's reserves have dwindled from $4 trillion to $3.33 trillion and are no longer far from the $2.6 trillion deemed to be the prudent threshold by the International Monetary Fund, given China's $1.2 trillion dollar liabilities.

We have a month of respite before we get new figures about capital outflows and forex declines, and in the meantime we have to watch out for soft China economic data and the yuan fix and spread between onshore and offshore yuan. And of course oil.

That means we could even rally if the yuan and oil hold, and we get some better than expected data out of China. This is exactly what happened overnight, as the slump in Chinese exports was less than expected (via Reuters):

China exports fell just 1.4 percent in December, much less than the expected 8 percent drop, allaying some concerns about the health of the world's second biggest economy.

The line of causation is clear. Better than expected data is likely to ease the fear about a hard landing and thereby ease the capital outflow out of China, which reduces the prospect for a substantial yuan devaluation.

The latter really is the prospects which is haunting the markets, as we explained (here). In order to assess the likelihood of such a devaluation in the month we have to wait for new forex figures, minute yuan movements is what the market turns to.

First and perhaps foremost is the movement in the yuan itself (CNY/USD, ETF: CNY). This is set by the People's Bank of China (PBoC) against a basket of currencies, and the daily fix is something that's widely watched.

In the figure of the last month (from Bloomberg), you see a falling yuan against the dollar, creating much of the panic:

Click to enlarge

You also see that the last couple of days, there has been stabilization, and guess what, the markets have also stopped going down.

Another useful indicator is the offshore market (Hong Kong), because market forces reign a bit more freely compared to the onshore market, which is fixed by the PBoC.

A couple of useful indicators are the spread between the onshore and offshore yuan, and the HIBOR.

If the offshore (USD/CNH) is falling more than onshore (USD/CNY), this is a sign of continued capital outflow, and this correlates pretty well with market trouble, like the VIX (NYSEARCA:VXX):

Click to enlarge

But, guess what, the offshore market isn't 'safe' from the PBoC either, when the spread gets too big, they tend to intervene. The tell tale signs of such interventions are:

  • A reduced spread
  • A spike in the HIBOR

Here is the FT:

China eased its purchases of offshore renminbi on Wednesday after succeeding in eliminating the gap between onshore and offshore exchange rates. The spread between the tightly controlled onshore US dollar rate for the renminbi and the rate offshore widened to a record of more than 2 per cent last week, as international investors bet the renminbi would weaken far more sharply than the People's Bank of China would like...

A byproduct of the PBoC's attempts to stem the speculation by intervention was a spike this week to a record high of 66.8per cent for the overnight CNH Hong Kong Interbank Offer Rate (Hibor), the cost of borrowing the currency in the territory. On Wednesday, Hibor plummeted to 8.3 per cent as liquidity returned to the market when the PBoC stepped back and the Hong Kong Monetary Authority, the de facto central bank, continued injecting support to banks.

That's quite a tightening, 66.8% on HIBOR. Still, longer-term we are not terribly optimistic about China's ability to keep the exchange rate up, for a number of reasons:

  • A byproduct of the forex intervention is domestic monetary tightening (although not nearly to the extent of that offshore spike in HIBOR as the domestic market is much more liquid). This tends to further weaken the Chinese economy and worsens debt dynamics.
  • The capital outflow seems to be accelerating, forex reserves dwindled by $108B in December, despite a substantial trade surplus. This cannot last at this speed.
  • The old stimulus model seems to have exhausted itself

On the latter, here is Daily Beast:

There have been six reductions in benchmark interest rates since November 2014 and five reductions of the bank reserve-requirement ratio since last February, but this monetary stimulus has had no noticeable effect, largely because there is a lack of demand for money.

They'll have to try something different, like restructuring the dead weight that exists in the enormous overcapacity and bad debts of many smokestack state-owned companies. You can't have creation without at least some destruction, unless you want a zombie economy like Japan in the 1990s.

Conclusion

The markets are extremely nervous about China, more specifically the yuan. A substantial devaluation of the latter will send deflationary shockwaves through an already very frail world economy.

Such devaluation would set financial markets substantially lower, we have little doubt about that. Last August and at the beginning of 2016 are only dress rehearsals.

We provided a few critical data points to keep a finger on the pulse of this risk, and hence your financial sanity.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.