Ok, it's that time again.
Time to revisit my favorite subject. The reddest black swan of them all: China and the ongoing yuan (NYSEARCA:CYB) devaluation saga.
As you're probably well aware by now, risk hates it when things get messy in China and the definition of "messy" is a widening spread between the onshore and offshore spots. Here's an updated version of my favorite chart in the world:
I've gone over the relationship more times than I can count (start here and work your way back) and trust me, it was taken as a given a long, long time ago on the Street.
When you see the spread between the onshore and offshore yuan blow out (i.e. widen), you can bet stocks (NYSEARCA:SPY) are going to fall. Why? Simple: it generally means that the offshore market is calling B.S. on the onshore market. In other words: the more freely traded yuan is pricing in further downside (i.e. depreciation) than its more tightly controlled onshore counterpart. More depreciation means accelerated capital flight, means more turmoil, means more hand wringing over China, means risk-off sentiment, etc., etc.
But lately we've seen something rather strange - this:
The market seems to have completely lost its ability and/or willingness to price in the depreciation that the offshore yuan is portending.
For those not familiar with how this works, you needn't learn the mechanics. All you need to do is look at the yellow and purple lines and ask yourself what was going on in global markets when they spiked. That's right: the yuan was depreciating and risk was tanking.
But now, the yuan is still depreciating and yet the market can't seem to price it. Here's SocGen's take:
The market reaction to CNH weakness is very interesting. It either suggests that investors are unwilling to put on large exposure or that the probability assigned to the tail risk of large devaluation has subsidised dramatically.
Speculative positioning could increase modestly over time, but the massive positioning that was evident in early January is unlikely. Ongoing intervention in various forms is dissuading speculators, especially as the painful squeeze in overnight funding that was engineered by the PBoC early in the year is still fresh on the minds of short term speculators.
Also, while short CNH positions (in forwards or options) are much cheaper that at any point since the August 11 devaluation, the negative carry positionis less appealing to many investors if the tail risk scenario does notcome to fruition.
Yeah, thanks for the decorum SocGen, but let's just cut the crap: the PBoC ain't havin' it. This devaluation is going to go according to their schedule by God, even if it bankrupts the entire country. Here, allow me to give you the full rundown from Wednesday's action via Bloomberg:
Yuan fixing was set at 6.69460 vs dollar, when some banks were expecting it to cross the 6.7 level, spurring broad USD/CNY and USD/CNH selling, traders say
Big Chinese banks led the sale of USD onshore at 6.6860, according to two traders
The strong fixing rate indicates China doesn't want to see yuan depreciation for now: Commerzbank
PBOC stepped in on capital outflow concern as depreciation expectation has been picking up after Brexit vote: BEA
CNY gains as mush as 0.28% today, most since June 3, to 6.6780 vs USD, while CNH rises as much as 0.29%
Zhou Hao (Asia EM economist, Commerzbank)
- Strong fixing rate indicates China doesn't want to see a CNY depreciation, at least for now
- Spiral effect of fixing mechanism decides that when USD strengthens overnight, yuan fixing would weaken, then market would sell CNY. Self-reinforcing depreciation expectation would only stop when USD stops rising
- Chinese authorities should conduct discretion in determining fixing rate to break self-reinforcing cycle
Harrison Hu (Greater China economist, RBS)
- Yuan fixing these few days are stronger than expected, which reflects PBOC's intention to defend USD/CNY near the 6.7 level
- "Fast pace" of decline recently is spurring response from policymakers
- PBOC wouldn't frequently defend yuan through lifting daily fixing
Kenix Lai (FX strategist, BEA)
- PBOC may have intervened this morning, leading to sharp decline of both USD/CNH and USD/CNY
- PBOC steps in on capital outflow concern as depreciation expectation has been picking up after Brexit vote
- USD/CNH has been above 6.70 for days; CNH 12-month forward points higher than in June
- Expects yuan to consolidate below 6.70 in near term, and depreciate in 2H as fundamentals for China are weak and exports outlook is sluggish
Gao Qi (Asia FX strategist, Scotiabank)
- PBOC is trying to manage market expectation because a swift decline through 6.70 may lead to faster depreciation
- Yuan depreciation vs both USD and basket will continue in 2H as capital outflows persist
- PBOC will step in to curb extreme movements if necessary
And here's Citi on the fix:
...several market participants will likely continue to watch the psychologically important 6.70 mark for USDCNY fixing. We believe that predictability of the fix, modest intraday price moves, slower reserves depletion and stable data will continue to serve as a source of considerable comfort for market participants. Nevertheless, sans official intervention, a break of 6.70 on fix might drive some near term interest for weaker renminbi. This may also let investors take a pause in adding to bullish exposure in other Asian currencies.
Correct, and it may also lead investors to "pause in adding to bullish exposure" to anything other than havens.
There's no way Beijing can keep a lid on this forever. As SocGen noted earlier this month and as I reiterated in the piece linked above, the yuan turmoil "will be back," and when it comes, look out below.
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.