Drink Horses, Drink!

| About: SPDR S&P (SPY)

Summary

There's an old saying about horses and water.

Who knew it would be applicable to the relationship between US stocks and the Chinese yuan.

I refuse to let my horses go thirsty.

Well, you know what they say: "you can lead a horse to water but you can't make it drink."

But that's not going to stop me from trying. After all, I've been known to beat a (dead) horse or three.

On Tuesday morning I gave you the most important chart in the world. For those who missed it, here it is:

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I'm not going to rehash the entire narrative here because I did quite a thorough job of that already in the original piece (which I think you'll enjoy if you haven't read it), but here's the Cliffs Notes version, in bullet points:

  • China needed to devalue their currency because the yuan's (NYSEARCA:CYB) dollar peg was dragging it higher against the currencies of the country's other trading partners, making exports less competitive at a time when growth was already decelerating sharply
  • China devalued in August
  • The market sensed more downside ahead and expressed that view via the offshore yuan, which generally trades more freely than its onshore counterpart
  • Thus, the spread between the onshore and offshore spots is a proxy for the extent to which the market thinks the onshore yuan doesn't reflect the risk of further downside
  • More downside means more outflows, more exported deflation, and more risk-off-ish type stuff
  • Risk-off-ish type stuff is bad for stocks
  • Therefore, when the onshore-offshore basis widens as the latter trades weaker than the former, US stocks (NYSEARCA:SPY) come under pressure

What I didn't mention (because you know, decorum and all that), is that this isn't a "theory." It's a fact. Remember that 1,000 point drop in the Dow on the morning of August 24? That wasn't attributable to some kind of bearded, trader-Zeus arbitrarily hitting the NYSE with a lightning bolt from on high because he was irritated at Hera. For the non-mythology buffs, that translates to this: the flash-crashing madness you witnessed on August 24 didn't come out of left field. It was directly related to China's yuan devaluation.

So what I'm going to do here is show you some charts. This will be like a Rorschach test administered by Heisenberg (that sounds kind of scary actually). I'll show you a chart and you tell me what you see. Don't worry, they'll be clues in big red letters with lots of annoying red, dashed arrows to help.

Let's get started because while I may have all day, you probably don't.

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(Chart: BofAML, my additions)

What do you see?

(Chart: BofAML, my additions)

What do you see?

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What do you see?

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What do you see?

But wait, there's more. Just have a look at the CNH (offshore yuan) and the cross-currency swap (NYSE:CCS) rate:

(Chart: Deutsche Bank, my additions)

I mean for God's sake, the CNH CCS curve was inverted in January! Look at the curves now, think about what US stocks have done since February and draw conclusions:

(Chart: Deutsche Bank)

Need more? No problem. Heisenberg has you covered. Look at HIBOR (a measure of interbank funding stress) in the right pane:

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(Charts: Deutsche Bank, my additions)

What's HIBOR got to do with it? Well, think about it. When you exchange offshore yuan for dollars (i.e. when the offshore yuan is getting weaker), you're reducing aggregate yuan deposits. Additionally, when the PBoC steps in to close the onshore/offshore gap, they're selling dollars and buying offshore yuan, thus sucking out CNH liquidity. Here's Deutsche Bank:

When CNH trades cheaper than CNY, offshore RMB liquidity tends to tighten because: a) depositors converting CNH into USD or other currencies would reduce the offshore RMB deposit base when banks settle the balances with the central bank under the cross-border RMB transactions arrangement; b) cross-border relative value trades conducted by corporations with access to both onshore and offshore market (i.e., buy CNH offshore and sell CNY onshore) effectively drain offshore RMB liquidity into the onshore market; c) FX market interventions to smooth RMB exchange rate volatility, if any, would also drain offshore RMB liquidity; d) required reserve payment on offshore RMB deposits reduces the potential supply of onshore RMB into the offshore market.

So there you go. Horses, meet water. Now drink.

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For anyone still not convinced, I'll leave you with the following three visuals. The top pane is CNH vol (inverted) graphed with the S&P. Note the bottom right pane. The correlation so far this year is almost perfectly negative. As CNH vol rises, US stocks fall.

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Drops mic. Walks off stage.

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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.