Is China Really Driving Today's Price Action?

After falling sharply in recent days, especially yesterday after the disappointing jobs data, the US dollar is broadly higher today, with the yen the main exception.  It has strengthened by almost 1% today.  

Many are attributing the price action to news that the five largest Chinese banks tripled the bad loans written off in the first half of the year to CNY22.1 bln (~$3.65 bln). Yet, tellingly and importantly, the Chinese banks had already made the provisions and thus did not, reportedly, impact the record profits (~$76 bln) in H1.  

There is some speculation that this is a precursor to a wave of defaults, but in itself writing off the bad loans is a very important step in its own right.  It is a step toward modernization and liberalization.  Provisioning for bad loans and then drawing on those provisions is part and parcel of a modern banking system.    

Precisely why one would sell, say the New Zealand dollar, the weakest major currency today, losing about 1.4% through the European morning, or the Mexican peso, which, with a 0.8% loss is the weakest among the emerging market currencies, in response to Chinese banks writing off bad loans in the first half of the year, is not immediately self-evident.   Indeed, not writing off bad loans, we would argue, was part of the problem.  Writing off bad loans is part of the solution.  For the record, the yuan itself rose to a new 20-year high against the dollar.  

There is another liquidity squeeze in China today.   Corporate tax payments are draining liquidity and thus far the PBOC has not deemed it necessary to counter this.  However, after money market rates jumped the most since July, the PBOC is likely to respond tomorrow.  The 7-day repo jumped 47 bp to 4.05% and the 1-day repo rose 72 bp to 3.80%.  

The PBOC's ability to manage the liquidity conditions seems clumsy and often responding belatedly to clear signals of important imbalances.  Admittedly, at times, the PBOC may be trying to send a signals of displeasure, like it did earlier this year, about wealth management products and shadow banking.  That does not seem to be the intent now.  

The firmer headline CPI, though still concentrated on food prices and not the general price level, and rising house prices has spooked some investors who feared a policy response.   The rise in money markets is not a prelude to a rate hike or a snugging of monetary policy.   That is in fact, the point, there is no policy implication, except to reinforce the perception of the PBOC's difficulty in managing liquidity.  

The rise in money market rates may be a key spur to the largest decline of small company share prices in a year and a half.  The ChiNext index of small companies fell 2.9% today, more than twice the decline of Shanghai Composite.  In comparison, Japan's JASDAQ fell 0.8%, while the Nikkei lost almost 2%.  

It strikes us that many observers seized upon the story to explain the price action throughout the capital markets.  We suspect that if the markets were advancing, many would cite Chinese developments too.  Instead, we suggest there have been some large moves in recent days, and the new positions were in weak hands.  That is to say, the dollar and yen's bounce and the pullback in shares is more a function of market positioning than Chinese banks finally writing down bad loans four months ago, for which provisions were already made. 

The dollar had fallen to new two year lows against the euro and Swiss franc.  The euro had firmed to four month highs against the yen.  The Dow Jones Stoxx 600 was on its longest winning streak (nine sessions) almost 3.5 years.  

There were really no surprises in the BOE minutes, though sterling has dropped a penny.  If anything the minutes were more in line with the market's assessment:  that the former Bank of Canada governor under-estimated the strength of the UK economy and that the general view among the MPC is that the jobless rate could actually be lower than envisaged two months ago. This implies that rate may rise earlier than previously suggested.  

If this analysis is correct and it is not so much China as a normal technical move, the euro is likely to find in front of the $1.3700.  Sterling has nearly reversed the entire gains scored on the disappointing US jobs data.  A break of yesterday's low near $1.6116 could signal a move toward $1.6075.  Ahead of what should be a good Q3 GDP report on Friday, the sterling bulls may try to weather the counter-trend move today.  

The Australian dollar's technicals are more worrisome.  A key reversal is in the works.  Initially the Aussie rallied on the slightly higher than expected headline inflation report (though the trimmed mean and weighted median were in line with expectations) and now has proceeded to sell-off, through yesterday's lows.  A close of the North American session below $0.9044 would confirm the key reversal, encouraging short-term players to look for follow through selling in Asia on Thursday.  

The dollar is trading just below its 200-day moving average against the yen that is found just below JPY97.30 today.  The dollar has not finished a North American session below this long-term average since November 2012.  Back on Oct 4, the dollar had flirted with the 200-day moving average that came in just above JPY96.70.  It fell to near JPY96.55 and than recovered to briefly poke through JPY99 on Oct 17.  It staged a key reversal then and there has been follow through selling generally since.  

The Canadian dollar is on the defensive today.  The US dollar is testing a 2-week downtrend line that comes in near CAD1.0345 today,which also corresponds to a 50% retracement of the losses over that two week period. A push through there could signal a near-term move to CAD1.04.