USD/CNY: More Upside In Store For 2016?

by: The Market Master

Summary

We introduce an economic forecasting tool using leading indicators to measure economic health.

The U.S. economy continues to show better fundamentals than the Chinese economy, based on this forecasting tool.

We expect to see a higher USD/CNY into 2016.

With so many news headlines being made about the Chinese Yuan joining the IMF SDR basket, as well as the well documented debt issues facing Asia. We thought we would do a little bit of a projection into next year, where the USD/CNY may go purely based on macroeconomic data points as well as a little bit of technical analysis. We will revisit this at the end of next year to see if it played out as expected.

To analyze the macroeconomic scorecard bit for the United States and China, we picked out 10 indicators in our opinion that are leading indicators as to how an economy would perform into next year and scored them accordingly. We will then use this data to draw some conclusions about the US and Chinese economies.

Once this is done, we will then do some technical analysis at the end though we do warn that because the USD/CNY is a controlled currency that technical analysis may not work as well as with freely traded G10 FX. Much less with a longer term projection.

So, without further ado let us have a look at the ten data indicators which are leading indicators in our opinion, and the rationale for using these indicators, and how the scoring will be done.

The Economic Scorecard:

  1. PMI Manufacturing Data. PMI data from the manufacturing end stands for the Purchasing Manager's Index in a country's manufacturing sector. A reading of over 50 indicates expansion, whilst below means contraction. It is used by many governments to determine business confidence as businesses would not increase their purchasing if they were not confident of increased volume or profitability. How it will be scored:

A score of 0 will be accorded If the latest PMI is over 50 and there is a flat or rising trend over the last six months

A score of 5 will be accorded if the latest PMI is over 50 but the trend is declining over the last six months

A score of 10 will be accorded if the latest PMI is below 50 and the trend is flat or declining over the last six months.

  1. PMI Service Data. PMI data from the service end stands for the Purchasing Manager's Index in a country's service sector. A reading of over 50 indicates expansion, whilst below means contraction. It is used by many governments to determine business confidence as businesses would not increase their purchasing if they were not confident of increased volume or profitability. Measuring the service sector PMI helps to complete the picture for most economies as manufacturing and services are usually the key sectors for any economy. How it will be scored:

A score of 0 will be accorded If the latest PMI is over 50 and there is a flat or rising trend over the last six months

A score of 5 will be accorded if the latest PMI is over 50 but the trend is declining over the last six months

A score of 10 will be accorded if the latest PMI is below 50, and the trend is flat or declining over the last six months.

  1. Consumer Confidence Data. The consumer confidence numbers help to determine how individuals in the country are feeling about an economy. In general, a declining number indicates consumers are pessimistic and will likely spend or invest less going forward which would weigh on corporate earnings and hence the economy at large. Vice versa, if it is increasing it is expected money will be spent more readily that would lead to an expanding economy. How it will be scored:

A score of 0 will be accorded if a rising trend is seen over the last six months

A score of 5 will be accorded if a flat to slightly declining trend is seen over the last six months

A score of 10 will be accorded if the trend is declining over the last six months.

  1. Retail Sales Data. Year on Year retail sales numbers help to confirm the consumer confidence picture and is often a better gauge of real consumer sentiment vs. jobs and employment numbers. The logic is very simple, in that most people will not spend unless they are confident about their financial future and their basic needs have been met. How it will be scored:

A score of 0 will be accorded if a rising trend is seen over the last six months

A score of 5 will be accorded if a flat trend to declining trend is seen over the last six months

A score of 10 will be accorded if the trend is declining over the last six months.

  1. The Stock Market trend. The stock market is often a good forward gauge of the economy at large because investors are often the first to flee when they see signs of trouble in a company's earnings prospects. As such, the six month trend in the stock market is likely a good gauge as to what investors see going forward in the market for the next six months which is often a good forward leading indicator of how the economy is going to do down the road. How it will be scored:

A score of 0 will be accorded if the stock market has gained > 3 % over the last six months

A score of 5 will be accorded if the stock market returns are between -3% and 3% over the last six months

A score of 10 will be accorded if the stock market has declined > 3% over the last six months.

  1. Construction Output/ Spending. Construction output or spending helps to confirm if economic activity is doing well in a country as increased building activity indicates increasing demand due to consumers upgrading or expanding is a sign of economic confidence. Naturally, continually decreasing construction output numbers suggest that demand is falling because of a lack of confidence on the side of consumers and businesses. How it will be scored:

A score of 0 will be accorded if a rising trend is seen over the last six months

A score of 5 will be accorded if a flat to declining trend is seen over the last six months

A score of 10 will be accorded if the trend is declining over the last six months.

  1. New vehicle sales/ registrations. If buying a house or upgrading your business real estate premises means you are confident of your prospects going forward, then buying a vehicle for transport certainly helps to confirm that. A drop off in vehicle sales or registrations usually indicates consumer confidence is falling and is usually a prelude to falling construction output and spending activity which hurts the economy. In general, our first choice would be to look at vehicle sales, but if that data is not available then we will use vehicle registration numbers. How it will be scored:

A score of 0 will be accorded if a rising trend is seen over the last six months

A score of 5 will be accorded if a flat to declining trend is seen over the last six months

A score of 10 will be accorded if the trend is declining over the last six months.

  1. Changes in Inventories. Businesses not being able to move inventory is always a warning sign and a inventory build ups should always be noted with caution. Of course, it could be argued that maybe inventory build ups are because economic activity is rising and so businesses stock up more to prepare for more sales. This is where the PMI data helps to balance out this measure because a rising PMI number would indicate that businesses are preparing for higher demand than usual. A drop in PMI numbers and rising inventories is usually a very unhealthy sign of economic activity in a country, as it indicated that businesses are unable to move their inventory. How it will be scored:

A score of 0 will be accorded if a falling trend is seen over the last six months relative to the previous year's same six months period

A score of 5 will be accorded if a flat trend is seen over the last six months relative to the previous year's same six months period

A score of 10 will be accorded if a rising trend is seen over the last six months relative to the previous year's same six months period

  1. Yield differential between 3mth and 10year yield. The yield theory here is that the difference in yield for the greater risk taken for the 10-year bond over the 3mth money market rate should not differ too much from the one year average. A fall to below the average indicates market participants see inflation tapering off due to a lack of spending and activity in the economy and could lead to a slowdown or recession that would result in rate cuts. An inverted yield curve will also have a score of 10 naturally. How it will be scored:

A score of 0 will be accorded if the yield differential is higher than the average over the last year by more than one standard deviation.

A score of 5 will be accorded if the yield differential is lower than the one year average but less than one standard deviation from the one year average.

A score of 10 will be accorded if the yield differential is lower than the one year average and more than one standard deviation from the one year average.

  1. Money Supply M0, M1, M2 & M3. In general, a decreasing money supply across the board indicates tightening across the board which usually means there less to spend and invest in, whilst an increasing supply indicates ample money to spend and invest. As such, money supply is tracked closely to see how conditions are on the ground for the economy at large. How it will be scored:

A score of 0 will be accorded if there is a rising trend

A score of 5 will be accorded if there is a flat to declining trend

A score of 10 will be accorded if the trend is declining

The final scoring:

Once we have scored each of the 10 categories, we will then tally up the total score. A score below 50 indicates a low risk of a recession in the economy. A score at 50 indicates that the risk of a recession is rising for the economy if data points keep pointing downward. Finally, a score above 50 indicates that the risks of a recession are high for an economy, with a score above 70 seen as a critical danger zone for an economy.

So how do the U.S. and Chinese Economy look through the lens of this tool?

The U.S. Economy:

PMI Manufacturing Data. Over the last six months, we have seen a steady decline in US manufacturing PMI data with the exception of a jump in October, though the number remains over 50. This downward trend based on our scoring system would have to be accorded a 5.

PMI Service Data. Over the last six months, we have seen a steady decline but stabilizing in US service PMI data, though the number remains over 50. This downward trend based on our scoring system would have to be accorded a 5.

Consumer Confidence Data. Over the last six months, we have seen a steady decline in U.S. consumer confidence numbers with data looking to turn upwards. This downward trend based on our scoring system would have to be accorded a 10 until we get a confirmed turnaround in data back to around the 95 level.

Retail Sales Data. The YoY retail sales numbers over the last six months for the U.S. is flattish after a period of a continued decline from the previous six months. Seeing the flattish pattern which has come after a continued decline, our system accords a score of 5, which may be a little lenient considering the big drop from October 2014, but for now we will give the U.S. Consumer the benefit of the doubt and will be watching for the December numbers to decide a final score.

The Stock Market trend. The U.S. Stock market is slightly negative over the last six months. Based on our scoring system we accord a 5 for this category.

Construction Output. U.S. Construction spending has fallen dramatically after hitting a high in April 2015. Based on this data, our scoring system accords a 5 in this category, which will increase to a 10 if the next quarter's data shows further slowing in US construction spending growth.

New vehicle registrations/ sales. There is a continued uptrend seen in US vehicle sales over the last six months which shows strength though it looks to tapering out a bit recently. Based on the data, our system accords a 0 for this component for the time being.

Changes in Inventories. Based on the chart, inventories have been rising over the last six months before a recent drawdown. Based on this data, our system accords a 0 for this component for now.

Yield differential between 3mth and 10year yield. The average yield differential between the U.S. 10year and 3month T-bill yield is 210.228bps with a standard deviation of 16.2493bps. The current yield differential stands at 210.6385bps. Based on our scoring system this is accorded a 0.

Money Supply M0, M1, M2 & M3. Based on M0, M1 & M2 data there is no decreasing money supply seen over the last six months. Based on our scoring system this is accorded a 0.

U.S. Economy results:

So how does the U.S. economy fair? The total score for the U.S. economy currently stands at 35, which means that there is a low chance of a recession currently going into next year. Back in 2000 and 2007, the score was well over 70, which gave very clear signals of the recession to come the following year. Some of the key bright points in the economy are the U.S. consumers who have continued to really hold up the economy despite sluggish corporate growth.

The Chinese Economy:

PMI Manufacturing Data. The Chinese manufacturing PMI has more or less plunged over the last six months with only some recovery in the last 2 months and is below 50. Based on our scoring system this is accorded a 10.

PMI Service Data. The Chinese services PMI data has been on the downtrend over the last six months but remains over 50. Based on the scoring system this is accorded a 5.

Consumer Confidence Data. Chinese consumer confidence has been on the downtrend over the last six months. Based on the scoring system this is accorded a 10.

Retail Sales Data. Chinese retail sales have managed to stage a recovery in the last six months. Based on the scoring system this is accorded a 0.

The Stock Market trend. The stock market gauge which is the Shanghai Composite has lost more than 20% over the last six months. Based on our scoring system, we accord a 10 for this.

Construction Output. Construction output in the form of Chinese GDP from construction has shown some decrease YoY over the last six months relative to 2014 as house prices in the mainland stagnate. Based on this, we accord a score of 5 to the component for the time being until the next quarter's data is released.

New vehicle registrations/ sales. Chinese vehicle sales have staged a recovery over the last six months. Based on this metric we have accorded a score of 0 to this component for now.

Changes in Inventories. Inventory build-ups by Chinese firms are high though more or less stable at this point. Based on this, we accord a score of 5 to this component until we see a change in trend.

Yield differential between 3mth and 10year yield. The average yield differential between the Chinese 10year and 3month T-bill yield over 1 year is 83.1021bps with a standard deviation of 54.6925bps. The current yield differential stands at 74.00bps. Based on our scoring system this is accorded a 5, showing some signs of stress at this juncture with yield differentials between long term Chinese bonds and short term money market rates falling below the 1 year average.

Money Supply M0, M1, M2 & M3. There has been a marked decrease in money supply on the M0 side though M1 & M2 show no signs of tightening conditions. For now, we will accord a score of 0 to this component but will increase it to a 5 if we start to see M1 and M2 numbers starting to decline.

Chinese Economy results:

So how does the Chinese economy fair? The total score for the Chinese economy currently stands at 50. This means that the jury is still out with regards to how the Chinese economy will fare into 2016. Back in October the score for the Chinese economy was 75. It remains to be seen if the Chinese government can steer the economy further in the right direction to avoid a hard landing into 2016-2017. This may involve more easing by the PBOC in order to achieve these growth objectives.

Using Technicals to predict the USD/CNY

Now that we have ascertained using our macroeconomic tool that the fundamentals of the U.S. Economy are outperforming that of China, a logical conclusion would be that a higher USD/CNY should be seen in the next year or two. The question then is, how high will the pair go?

Based on technicals alone, our preferred path would be for the USD/CNY to trade back down to around the 6.27 levels on the back of the positive expectations from the IMF SDR news, before resuming a longer term uptrend move toward the 6.67 level as diverging monetary policies begin to take hold.

Conclusion

Based on the fundamental front of relative economic strength, the United States continues to outperform China in terms of leading indicators based on our tool. One might even argue the outperformance is even more stark than at first glance due to the questionable reliability of the Chinese economic data. This fundamental piece, the technical picture and the diverging monetary policy stances between the Fed and PBOC should eventually lead to a higher USD/CNY into 2016 in our opinion. In the short term some CNY buying maybe seen though this to us remains an opportunity go long the USDCNY NDF into the New Year to play the expected strengthening of the USD against the Chinese Yuan with a target around the 6.67 level. We will be monitoring how this plays out weekly and will give an update of any changes in expectation on our site.

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.