Markets Ease Exaggeration, Dollar and Stocks Recover

It is understandable.  China's move on Tuesday caught the market off-guard.  After seemingly re-pegging the yuan to the dollar, it pushed it reset the yuan to the lower end of its 2% band and announced a new mechanism that seems still to be largely a "black box",  in the sense of lacking much transparency.  

Investors over-reacted to what is ultimately a relatively small move in the yuan.  The yuan is off about 3%, with the offshore yuan (CNH) off a bit more.  It may help some small companies with narrow profit-margins, but on the whole, the move is far too small to change China's export competitiveness.  The key to China's exports is stronger world growth, which is why exports to the US have risen but not to Europe or Japan. 

The Chinese move unsettled markets.  The main concern was not what investors knew, but what they did not know. The unknowns were two-fold.  How much devaluation was China seeking and how would others respond.   

Through intervention to support the yuan, yesterday and some talk of a similar operation today, and guidance by PBOC officials, the engineered depreciation is nearly complete.  However, China has introduced a new mechanism that is too give market forces greater sway.  Given the slowing of the Chinese economy and the prospects of Fed tightening, the yuan, like other currencies  in those circumstance should decline.  

Many investors, already primed to think in currency war terms feared a new front had opened.  Yet, outside of some in the media and a few analysts, few took the bait.  We note that the IMF and US Treasury welcomed the move, provided that it was implemented as the declaratory policy implied.  Yesterday, Dudley, President of the NY Fed recognized that given macro situation in China, it would "not be inappropriate" for the yuan to weaken.    Moreover the fact that the South Korean and Philippines central banks, both of which had meetings today, did not respond to the yuan's depreciation, also suggests the currency war meme has once again been exaggerated. 

Nor does the yuan's modest pullback or the short-term volatility in the capital markets impact the Fed's decision in a little more than a month’s time.   It has been a light week for US economic data to help investors anchor views, and today's retail sales report likely will be helpful.  The consensus expects a 0.6% increase in July retail sales after the 0.3% fall in June.  The GDP component (excluding auto, gasoline and building materials)  is expected to rise 0.5% after declining0.1% in June.  The risk, we suspect, is on the upside, though acknowledge that the impact of Amazon's Prime Day and the competitive response by other large retailers is difficult to assess.  

The markets equilibrium appeared to have begun returning in the North American afternoon yesterday, and there has been further follow-through today as the pendulum of continues to correct the over-shoot.   The US 10-year yield is 10 bp above yesterday's low print.   The two-year yield is six bp higher.  The S&P 500 gapped lower, below its 200-day moving average, but recovered fully to close fractionally higher on the day.  Asian and European equities have also recovered.  The dollar is also recovering.  It is higher against all the major currencies, save sterling and the Swedish krona. 

The krona is easily the strongest currency today, rising almost 1% against the dollar and 1.4% against the euro.  The driver was the higher than expected inflation reading.  The July CPI was unchanged, whereas the consensus was for a 0.3% fall.  This saw the year-over-year rate rise to -0.1% from -0.4%.  The underlying rate, which used fixed mortgage interest rates, but does not exclude food or energy as core rates typically do, rose to 0.9% from 0.6%.  The consensus expected an unchanged rate.  The Riksbank meet on September 3, and ideas that it would expand its bond buying program or cut rates deeper into negative territory are being re-thought. 

Since the end of June, the euro appreciated nearly 5% against the krona, from below SEK9.20 to almost SEK9.63 at the start of this week.  Today's move has seen the euro surrender 38% of those gains (~SEK4.46), which also corresponds to the 20-day moving average.  A break of this area would target SEK9.40, and possibly SEK9.35.  

The dollar briefly dipped below JPY124 yesterday but recovered with US yields and stocks in the second half of the session.   Although Japan revised up June industrial output to 1.1% from 0.8%, the market paid more attention to the unexpectedly large drop in machine orders, which are seen as a lead indicator for capex.  Machinery orders fell 7.9% in June.  The consensus was for a 4.8% decline.  Early Monday in Tokyo, the first estimate of Q2 GDP will be reported.  The consensus expects a 0.5% decline quarter-over-quarter.  

First though, Prime Minister Abe has called a special cabinet meeting tomorrow.  Details are not available, which means speculation has the upper hand.  Three potential topics are being suggested:  WWII commemoration, re-starting of a nuclear plant this week, and a response to Chinese developments.   If the issue is indeed one of these three, we are more inclined to the first.  The second likely has already been discussed.  The third is part of the previous exaggeration. 

Lastly, we note that Greece reported Q2 GDP at 0.8%.  The consensus was for a 0.5% contraction.   A healthy skepticism greeted the announcement.  The focus on Greece is two-fold.  First, later today Greece’s parliament is expected to vote on the two measures to endorse the third aid package.  Second, Germany is still balking.  Remember 60 MPs in Merkel’s CDU/CSU did not want to enter into such talks in the first place.  Apparently with the summer holidays, the cajoling, arm-twisting, and deal making, to ensure a favorable outcome is more difficult.  A bridge loan option is still being pushed, it appears.  

For its part, the euro peaked yesterday near $1.1215, which is within a whisker of the July 10 high.  Some will see this as a potential (bearish) double top.  Even so, it would only re-emphasize the significance of the $1.08 support.  Since the US jobs data, the euro has rallied from roughly $1.0855 to $1.1215.  Assuming that move is complete, the first retracement is near $1.1080.  There are other technical targets in the $1.1030-60 area.   

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