"Dude, This Is Huge": An FX Bombshell And A "Basket" Case

| About: WisdomTree Chinese (CYB)
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Summary

August 11, 2015 was a day which will live in financial market infamy.

Indeed we still do not know the extent of the fallout from China's dramatic devaluation of the yuan.

One thing we do know: the basket approach doesn't work in a strong dollar environment.

Dude, this is huge.

That's the four word message I sent to one of my co-workers on the evening of August 10. He had just posted a Bloomberg headline to our internal chatroom, but I had already seen it about 45 seconds prior in my inbox. China had cut the daily yuan (NYSEARCA:CYB) fixing by nearly 2% in a supposedly "one-off" move that promptly reverberated through global capital markets and ultimately set the stage for a very "black" Monday on August 24.

If you're serious about following markets, August 11 was one of those "I remember where I was when..." moments. Indeed, I remember exactly where I was and precisely what I was doing.

Little Buddha (a painfully generic Asian fusion joint) was always more than happy to deliver, but I'd been staring at the terminal since around 4:45 a.m. I needed to stretch my legs and ordering carryout instead of delivery gave me an excuse to walk a few extra blocks and enjoy the not-so-fresh city air. I figured I'd get there early and have a chilled shot of Tres Generaciones Plata with the bartender, a fiery Puerto Rican girl who was paying her way through nursing school with tips from the Heisenbergs of the world.

Within an hour I was fumbling for my condo keys, a plastic sack full of sushi in one hand and a Hermes messenger bag slung awkwardly over one shoulder. I stumbled in the door, tossed the bag on the counter, plopped down on the couch, and proceeded to spread dinner out on the coffee table. Once I was all set up I refreshed the Bloomberg e-mails on my phone. I caught the China deval story the minute it hit. I pushed the sushi to one side, hastily opened my MacBook Pro, logged into chat, and didn't get to sleep until nearly 3.

The financial world changed that day. Things haven't been the same since. Suddenly, the market woke up to the likely implications of a mass FX reserve liquidation by a major holder of US debt. It also quickly occurred to those with a sense of market history that capital was about to start flowing the wrong way out of China. Fast forward two Mondays and the Dow opened lower by 1,000 points: Investors had, with a multi-session delay, finally managed to put all of the pieces together. They did not like what they saw.

Three months later, in December, China blindsided markets yet again by adopting a trade-weighted currency basket as a reference point for the RMB. Most analysts saw through the charade immediately. "The PBOC is clearly preparing the market to interpret a weaker yuan against the dollar as not being devaluation," SocGen said at the time. "By referencing a basket of currencies, we believe the PBOC is leaving more room for further CNY depreciation against the dollar in the future," BofAML added.

Essentially, the PBoC knew that keeping the RMB stable against the basket would mean letting the currency depreciate further against the USD (NYSEARCA:UUP) in a strong dollar regime. Should anyone point to excessive yuan weakness versus the dollar, Beijing could simply reference the RMB's relative stability against the basket.

Ok, so here's the problem with this approach: In a market characterized by a structurally strong USD, the link to the TWI essentially presages a one-way trajectory for the RMB. Consider the following commentary and visual from Citi (note that some of the numbers are about a month old, but in this case that's actually a good thing because the market moves since then have actually gone some way towards proving Citi's thesis):

The current basket approach to managing the RMB's valuation indicates there is only a one-way depreciation path for the RMB exchange rate in a strong dollar environment. Based on our forecasts on other currencies, and assuming the authorities will maintain stability of the CFETS and the SDR currency baskets (Figure 15), we can readily estimate that in three months, if the DXY index stays at 101.9, JPY, CHF, RUB and THB appreciate, while rest of the currency basket depreciates against USD, the RMBUSD would devalue steadily to 6.924 (in CFETS basket) or 6.930 (in SDR basket). In 6-12 months, if the DXY index were to surge to 108.45, followed by the large depreciation of EUR, GBP and AUD (and all other currencies in the baskets except RUB devalue), the CNYUSD would be at 7.151 (in CFETS basket) or 7.232(in SDR basket). These simple exercises indicate that the currency basket approach to anchoring the RMB exchange rate in a strong dollar environment will lead to a one-way depreciation direction of the CNY, potentially leading to large and disorderly capital outflow. Therefore, we believe the currency basket approach to anchoring the RMB valuation in a strong-dollar environment no longer works.

This is a critical point to grasp. While the TWI/ basket approach was a cute sleight of hand, it entails a perpetual weakening of the RMB in a strong dollar environment. And as I've documented on too many occasions to count (most recently here and here), this is a strong dollar environment.

In short, China is a "basket case" - literally.

And so, Beijing will ultimately have to go another route, and it doesn't look like an overnight free float is a particularly appealing way to go. But I'll save that discussion for another time.

For now, I'll simply leave you with a hilariously salient soundbite from UBS:

The PBOC is trying to actually stabilize the RMB against the dollar. It's trying to manage expectations among Chinese households and corporates so that you don't have this very mechanical, one-sided depreciation expectation.

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.