Economic Survival Motivates Free-Floating Chinese Yuan

Includes: CNY, CYB, FXCH
by: Learn Bonds

Last night, the Chinese government announced that it will allow the yuan to float more freely (have a looser peg is more accurate). The result is that the yuan has dropped sharply versus major currencies, including the dollar. Upon the news, China bulls hailed the move as a sign that the country is moving toward a freely floating currency and a more market-based economy. Although this might be true, eventually, economic reform does not appear to be the impetus behind the move to loosen the currency peg. Economic survival appears to be the Chinese government's motivation.

By allowing the yuan to price versus its prior day's close, the currency weakened by 1.9%. After many years of strengthening, there were signs in the currency markets that the yuan would weaken if the government would allow it to float more freely. Thus, it is in the interest of the Chinese government to loosen its grip on the value of the Chinese yuan. China has been criticized over the years for keeping its currency value artificially low versus major foreign currencies. As such, the country has strengthened the yuan by more than 30% during the past decade. However, with its economy slowing significantly, China could benefit from a weaker yuan. Now, under the guise of economic reform, it can weaken the currency.

The result is that the USD is rallying this morning, and the yield of the 10-year UST fell to 2.12% (at the time of this writing), as a stronger U.S. dollar is disinflationary. There are concerns in the markets that China's move to weaken the yuan could force other sovereign central banks to do likewise. If a currency war is ignited (reignited), dollar strengthening could pick up speed. Since a stronger USD can be a de facto monetary policy tightening, it calls into question the path of Fed tightening.

If the USD continues to strengthen, it could put a damper on the Fed's plans to tighten. Higher U.S. policy rates should also have a stronger dollar/lower inflation effect. I don't believe a stronger USD will dissuade the Fed from tightening this year (probably September), but it could slow the pace and reduce the magnitude of monetary policy tightening.

The sentiment among economists and strategists is that the current global disinflationary environment is temporary and cyclical. Fixed-income market participants view disinflation, slow wage growth and slackening global demand/reduced demand expectations as decidedly structural phenomena. Bond Squad believes that strategists and economists are overestimating the benefits of monetary stimulus by drawing parallels between the U.S. economy and foreign economies which are now in easing mode.

One must remember that when the Fed was easing aggressively following the financial crisis, few foreign central banks were easing aggressively. Thus, the U.S. economy was able to gain an advantage versus foreign economies. However, today, the situation is much different. Easing works best when one is unique in doing so. However, when most of one's trading partners are easing, it is difficult to gain an advantage in the global marketplace. It might be that easing in foreign economies is less effective because almost everyone is doing the same. The result could be a currency race to the bottom, with undersized benefits from stimulus. For the U.S., it could mean that Fed tightening has an outsized effect on prices. In other words, even a minor tightening could have major downward pressure on prices/price increases.

This morning, we continue to hear sell-side strategists warn investors not to underestimate the power of central bank stimulus around the globe. I would warn these bullish strategists to not overestimate the benefits of stimulus. Monetary policy stimulus is usually most effective in reflating economies until the economic cycle turns for the better. I would argue that what vexes global economies is much more structural (demographic, technological, and fiscal) than it is cyclical.

My forecast is for modestly positive inflation in the U.S. economy. However, we view the potential for higher or lower prices nearly equally. It is going to be challenging to boost inflation in an environment in which the U.S. dollar is strengthening because of currency devaluation overseas and tighter Fed policy. This could slow U.S. economic activity and blunt wage growth. If anyone sees how U.S. inflation should spike higher in the current environment (with countries such as China exporting disinflation), please tell us. Pointing to past occurrences will not suffice.

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